UNITED
      STATES


SECURITIES
      AND EXCHANGE COMMISSION


WASHINGTON,
      D.C. 20549


**F
      O R M 20 – F / A2**





o
            REGISTRATION
                STATEMENT PURSUANT TO SECTION 12(b) OR (g) OF THE SECURITIES EXCHANGE
                ACT
                OF 1934


OR


x
            ANNUAL
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                ACT OF
                1934


For
      the
      fiscal year ended December 31, 2006


OR


o
            TRANSITION
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                ACT OF
                1934


OR


o
            SHELL
                COMPANY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
                EXCHANGE
                ACT OF 1934





Date
      of
      event requiring this shell company report..........................





For
      the
      transition period from ________ to ________





Commission
      file number: 005-52583





**BLUEPHOENIX
      SOLUTIONS LTD.**


(Exact
      Name of Registrant as Specified in Its Charter)





**Israel**


(Jurisdiction
      of Incorporation or Organization)





**8
      Maskit Street, Herzlia 46120, Israel**


(Address
      of Principal Executive Offices)





Securities
      registered or to be registered pursuant to Section 12(b) of the
      Act:


Ordinary
      shares, NIS 0.01 par value





Securities
      registered or to be registered pursuant to Section 12(g) of the
      Act:


None


(Title
      of
      Class)





Securities
      for which there is a reporting obligation pursuant to Section 15(d) of the
      Act:


Ordinary
      shares, NIS 0.01 par value


(Title
      of
      Class)




Indicate
      the number of outstanding shares of each of the issuer’s classes of capital or
      common stock as of December 31, 2006:




14,298,358
      Ordinary shares, NIS 0.01 per share





Indicate
      by check mark if the registrant is a well-known seasoned issuer, as defined
      in
      Rule 405 of the Securities Act.





Yes
o
      No x




If
      this
      report is an annual or transition report, indicate by check mark if the
      registrant is not required to file reports pursuant to Section 13 or 15(d)
      of
      the Securities Exchange Act of 1934.





Yes
o
      No x





Note –
      Checking the box above will not relieve any registrant required to file reports
      pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 from
      their obligations under those Sections.





Indicate
      by check mark whether the registrant (1) has filed all reports required to
      be
      filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
      the
      preceding 12 months (or for such shorter period that the registrant was required
      to file such reports), and (2) has been subject to such filing requirements
      for
      the past 90 days.


Yes
x
      No o





Indicated
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated filer. See definition of “accelerated
      filer” in Rule 12b-2 of the Exchange Act. (Check one):





Large
                accelerated filer o
            
            Accelerated
                filer o
            
            Non-accelerated
                filer x






Indicate
      by check mark which financial statement item the registrant has elected to
      follow.





Item
      17
o Item 18 x





If
      this
      is an annual report, indicate by check mark whether the registrant is a shell
      company (as defined in Rule 12b-2 of the Exchange Act).





Yes
o
      No x







**TABLE
      OF CONTENTS**




P
                A
                R T I
            
            1ITEM
                1. IDENTITY OF DIRECTORS, SENIOR MANAGEMENT, AND ADVISERS
            
            2ITEM
                2. OFFER STATISTICS AND EXPECTED TIMETABLE
            
            2ITEM
                3. KEY INFORMATION
            
            2A.
            Selected
                Financial Data
            
            2B.
            Capitalization
                and Indebtedness
            
            3C.
            Reasons
                for the Offer and Use of Proceeds
            
            3D.
            Risk
                Factors
            
            4ITEM
                4. INFORMATION ON THE COMPANY
            
            17A.
            History
                and Development of the Company
            
            17B.
            Business
                Overview
            
            18C.
            Organizational
                Structure
            
            36D.
            Property,
                Plants and Equipment
            
            36ITEM
                4A. UNRESOLVED STAFF COMMENTS
            
            37ITEM
                5. OPERATING AND FINANCIAL REVIEW AND PROSPECTS
            
            37A.
            Operating
                Results
            
            46B.
            Liquidity
                and Capital Resources
            
            51C.
            Research
                and Development, Patents and Licenses
            
            56D.
            Trend
                Information
            
            56E.
            Off-Balance
                Sheet Arrangements
            
            57F.
            Tabular
                Disclosure of Contractual Obligations
            
            57G.
            Safe
                Harbor
            
            57ITEM
                6. DIRECTORS, SENIOR MANAGEMENT, AND EMPLOYEES
            
            57A.
            Directors
                and Senior Management
            
            57B.
            Compensation
            
            60C.
            Board
                Practices
            
            60D.
            Employees
            
            67E.
            Share
                Ownership
            
            68ITEM
                7. MAJOR SHAREHOLDERS AND RELATED PARTY TRANSACTIONS
            
            70A.
            Major
                Shareholders
            
            70B.
            Related
                Party Transactions
            
            71C.
            Interests
                of Expert and Counsel
            
            75ITEM
                8. FINANCIAL INFORMATION
            
            75A.
            Consolidated
                Statements and Other Financial Information
            
            75B.
            Significant
                Changes
            
            76ITEM
                9. THE OFFER AND LISTING
            
            76A.
            Offer
                and Listing Details
            
            76B.
            Plan
                of Distribution
            
            77C.
            Markets
            
            77D.
            Selling
                Shareholders
            
            78E.
            Dilution
            
            78F.
            Expenses
                of the Issue
            
            78ITEM
                10. ADDITIONAL INFORMATION
            
            78A.
            Share
                Capital
            
            78B.
            Memorandum
                and Articles of Association
            
            78C.
            Material
                Contracts
            
            81D.
            Exchange
                Controls
            
            82E.
            Taxation
            
            82F.
            Dividend
                and Paying Agents
            
            90G.
            Statement
                by Experts
            
            90H.
            Documents
                on Display
            
            90I.
            Subsidiary
                Information
            
            90





ii





ITEM
                11. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
                RISK
            91ITEM
                12. DESCRIPTION OF SECURITIES OTHER THAN EQUITY SECURITIES
            91P
                A
                R T II
            92ITEM
                13. DEFAULTS, DIVIDEND ARREARAGES AND DELINQUENCIES
            92ITEM
                14. MATERIAL MODIFICATIONS TO THE RIGHTS OF SECURITY HOLDERS AND
                USE OF
                PROCEEDS
            92ITEM
                15. CONTROLS AND PROCEDURES
            92ITEM
                16A. AUDIT COMMITTEE FINANCIAL EXPERT
            92ITEM
                16B. CODE OF ETHICS
            93ITEM
                16C. PRINCIPAL ACCOUNTANT FEES AND SERVICES
            93ITEM
                16D. EXEMPTIONS FROM THE LISTING STANDARDS FOR AUDIT
                COMMITTEES
            94ITEM
                16E. PURCHASES OF EQUITY SECURITIES BY THE ISSUER AND AFFILIATED
                PURCHASERS
            94P
                A
                R T III
            94ITEM
                17. FINANCIAL STATEMENTS
            94ITEM
                18. FINANCIAL STATEMENTS
            94ITEM
                19. EXHIBITS
            95





iii




*This
        Amendment No. 2 to Form 20-F (the “Amended 20-F”) contains information for the
        fiscal year ended December 31, 2006, which information was filed with the
        Securities and Exchange Commission on Form 20-F and Form 20-F/A on March
        30,
        2007 (the “Original 20-F”) and the consolidated financial statements contained
        therein (the “Original Financial Statements”); the certifications (Exhibits
        12.1, 12.2, 13.1 and 13.2) contained in the Original 20-F speak as of the
        dates
        specified. Item 5 of the Original 20-F has been amended to include additional
        disclosure relating to management’s discussion of the Company’s operating
        results. The consolidated statements of operations, as well as Notes 1 and
        11 of
        the Original Financial Statements, have been amended to include additional
        disclosure relating to revenue and cost of revenue line items, significant
        company policies and employee share option plans.*




*Except
      as specifically indicated, the Amended 20-F has not been updated to reflect
      events occurring subsequent to the filing of the Original 20-F. The filing
      of
      this Amended 20-F shall not be deemed an admission that the Original 20-F,
      when
      filed, included any untrue statement of a material fact or omitted to state
      a
      material fact necessary to make a statement not misleading.*




**P
      A R T I**







*Some
      of the statements in this annual report, including those in the Risk Factors,
      Operating and Financial Review and Prospects, and Business Overview sections,
      are forward-looking statements that involve risks and uncertainties. These
      forward-looking statements include statements about our plans, objectives,
      strategies, expectations, intentions, future financial performance, and other
      statements that are not historical facts. We use words like “anticipates,”
“believes,” “expects,” “future,” “intends,” and similar expressions to mean that
      the statement is forward-looking. You should not unduly rely on these
      forward-looking statements, which apply only as of the date of this annual
      report. Our actual results could differ materially from those anticipated in
      the
      forward-looking statements for many reasons, including the risks described
      under
      Risk Factors.*





*As
      used in this annual report, references to “we,” “our,” “ours,” and “us” refer to
      BluePhoenix Solutions Ltd. and its subsidiaries, unless otherwise indicated.
      References to “BluePhoenix” refer to BluePhoenix Solutions
      Ltd.*





*The
      name BluePhoenixTM and the names BluePhoenixTM IT Discovery, BluePhoenixTM
LogicMiner, BluePhoenixTM DBMSMigrator, BluePhoenixTM PlatformMigrator,
      BluePhoenixTM Rehosting, BluePhoenixTM LanguageMigrator, BluePhoenixTM
DataMigrator, BluePhoenixTM* *SOA-Ready Enablement* *(Formerly known as WS4Legacy,) BluePhoenixTM* *FieldEnabler* *,
      BluePhoenixTM* *StandardsEnabler* *,
      BluePhoenixTM* *COBOL/LE-Enabler* *,*  *BluePhoenixTM
      EuroEnabler, BluePhoenixTM Refactoring Repository (Nebula- code name),
      BluePhoenixTM AppBuilder, and BluePhoenixTM* *Redevelopment* *appearing in this annual report are trademarks of our company. Other trademarks
      in this annual report are owned by their respective holders.*





1




**ITEM
      1. IDENTITY OF DIRECTORS, SENIOR MANAGEMENT, AND ADVISERS**




Not
      applicable.




**ITEM
      2. OFFER STATISTICS AND EXPECTED TIMETABLE**




Not
      applicable.




**ITEM
      3. KEY INFORMATION**




**A.**  **Selected
      Financial Data**




The
      following tables present our consolidated statement of operations and balance
      sheet data for the periods and as of the dates indicated. We derived the
      statement of operations data for each of the years ended December 31, 2004,
      2005 and 2006 and the balance sheet data as of December 31, 2005 and 2006 from
      our consolidated financial statements included in Item 18 of this annual report,
      which have been prepared in accordance with generally accepted accounting
      principles as applied in the United States, or U.S. GAAP. Our consolidated
      financial statements have been audited by **** Ziv
      Haft
      registered public accountant (Isr.) BDO member firm. The selected consolidated
      financial data as of December 31, 2002, 2003 and 2004 and for the years ended
      December 31, 2002 and 2003 is derived from our audited financial statements
      not included in this annual report, which have been prepared in accordance
      with
      U.S. GAAP. You should read the selected consolidated financial data set forth
      below together with our consolidated financial statements included elsewhere
      in
      this annual report. See “Item 5. Operating and Financial Review and
      Prospects.”





2




**Year
                  Ended December 31,****2006**
              
              **2005**
              
              **2004**
              
              **2003**
              
              **2002****$****Consolidated
                  Statements of Operations Data:**
              
              **(in
                  thousands, except per share data)**Revenues
              
              $
              68,004
              
              $
              58,947
              
              $
              57,186
              
              $
              54,340
              
              $
              36,668Cost
                  of revenues
              
              
              28,515
              
              
              25,379
              
              
              24,253
              
              
              24,115
              
              
              15,220Gross
                  profit
              
              
              39,489
              
              
              33,568
              
              
              32,933
              
              
              30,225
              
              
              21,448Software
                  development costs
              
              
              9,400
              
              
              8,006
              
              
              8,055
              
              
              8,138
              
              
              7,387Selling,
                  general, and administrative expenses
              
              
              22,149
              
              
              21,611
              
              
              21,388
              
              
              20,140
              
              
              13,2457,940
              
              
              3,951
              
              
              3,490
              
              
              1,947
              
              
              816Goodwill
                  impairment, restructuring costs, and non-recurring
                  expenses
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              472Operating
                  income (loss)
              
              
              7,940
              
              
              3,951
              
              
              3,490
              
              
              1,947
              
              
              344Financial
                  income (expenses), net
              
              
              (3,515
              )
              
              (1,978
              )
              
              (882
              )
              
              165
              
              
              (195
              )Gain
                  on realization of shareholdings
              
              
              -
              
              
              -
              
              
              112
              
              
              376
              
              
              -Other
                  income (expenses), net
              
              
              282
              
              
              104
              
              
              975
              
              
              567
              
              
              (1,581
              )Income
                  (loss) before taxes on income
              
              
              4,707
              
              
              2,077
              
              
              3,695
              
              
              3,055
              
              
              (1,432
              )Income
                  tax expense
              
              
              (282
              )
              
              149
              
              
              260
              
              
              152
              
              
              1604,989
              
              
              1,928
              
              
              3,435
              
              
              2,903
              
              
              (1,592
              )Equity
                  in losses of affiliated companies, net
              
              
              -
              
              
              -
              
              
              (516
              )
              
              (898
              )
              
              (1,336
              )Minority
                  interest
              
              
              (317
              )
              
              (139
              )
              
              (73
              )
              
              (154
              )
              
              (702
              )Net
                  income (loss)
              
              $
              4,672
              
              $
              1,789
              
              $
              2,846
              
              $
              1,851
              
              $
              (3,630
              )Basic
                  earning (loss) per share
              
              $
              0.34
              
              $
              0.13
              
              $
              0.21
              
              $
              0.14
              
              $
              (0.35
              )Diluted
                  earnings (loss) per share
              
              $
              0.33
              
              $
              0.13
              
              $
              0.21
              
              $
              0.14
              
              $
              (0.35
              )Weighted
                  average number of shares outstanding
              
              
              13,889
              
              
              13,557
              
              
              13,523
              
              
              13,451
              
              
              10,517Weighted
                  average number of shares outstanding assuming dilution
              
              
              14,371
              
              
              13,973
              
              
              14,679
              
              
              13,644
              
              
              10,517




**December
                  31,****2006**
              
              **2005**
              
              **2004**
              
              **2003**
              
              **2002****$****Consolidated
                  Balance Sheet Data:**
              
              
              
              
              
              (in
                thousands)Working
                  capital
              
              $
              17,861
              
              $
              4,546
              
              $
              6,357
              
              $
              246
              
              $
              1,310Total
                  assets
              
              
              127,466
              
              
              99,691
              
              
              90,882
              
              
              80,820
              
              
              87,481Total
                  liabilities
              
              
              67,517
              
              
              47,925
              
              
              42,251
              
              
              35,422
              
              
              40,760Shareholders’
                  equity
              
              
              59,949
              
              
              51,766
              
              
              48,631
              
              
              45,398
              
              
              46,721




**B.**  **Capitalization
      and Indebtedness**




Not
      applicable.




**C.**  **Reasons
      for the Offer and Use of Proceeds**




Not
      applicable.





3




**D.**  **Risk
      Factors**




Our
      business, operating results, and financial condition could be seriously harmed
      due to any of the following risks. In addition, the trading price of our
      ordinary shares and convertible notes could decline due to any of these risks.
      Additional risks and uncertainties that we are not aware of or that we currently
      believe are immaterial may also adversely affect our business, financial
      condition, results of operations and our liquidity.





***Risks
      Related to Our Business***





**If
      capital spending on information technology, or IT, slows down, our business
      could be seriously harmed.**





We
      are
      affected by global economic changes, in particular trends in capital spending
      in
      the IT sector. During 2001 through 2003, the overall business slowdown in the
      North American and European markets influenced the purchasing patterns of
      leading software developers who delayed their planned orders and caused
      developers to reduce the amount of their planned license commitment. These
      changes in purchasing patterns in the IT industry directly affected our
      operating results. Although we believe that during the last three years the
      IT
      market has begun to recover, we cannot know whether the global market recovery
      will continue in the future, and how the economic conditions will continue
      to
      affect our business. Accordingly, we cannot assure you that we will be able
      to
      increase our revenues or keep our revenues at the same level as in 2005 and
      2006.





**Any
      future acquisitions of companies or technologies may distract our management
      and
      disrupt our business** .





As
      part
      of our growth strategy, we have invested in and acquired control of various
      companies to expand our solution portfolio. We intend to continue seeking
      investment opportunities. We may incur indebtedness or issue equity securities
      to pay for these acquisitions and investments. The issuance of equity securities
      could dilute our existing shareholders.





In
      addition, as part of our expansion strategy, we increased our controlling
      interest in some of our subsidiaries and fully integrated them within our
      business. We cannot assure you that we will be able to identify future suitable
      acquisition or investment candidates or, if we do identify suitable candidates,
      that we will be able to make the acquisitions or investments on commercially
      acceptable terms or at all. If we acquire, invest in, or increase our control
      interest in another company, we could have difficulty assimilating that
      company’s personnel, operations, technology, or products and service offerings
      into our own. In addition, the key personnel of the acquired company may decide
      not to work for us. These difficulties could disrupt our ongoing business,
      distract our management and employees, increase our expenses, and adversely
      affect our results of operations. Acquisitions of new companies, like the recent
      acquisition of CodeStream Software Ltd., also involve the risk of penetrating
      markets in which we have no or limited experience. For more information about
      the acquisition of CodeStream, see “Item 4.B. Business Overview–Investments and
      Acquisitions–CodeStream.”





4




**We
      have a limited operating history in our current principal markets, which will
      make it difficult or impossible for you to predict our future results of
      operations.**





We
      have
      experienced major fluctuations in our net results. In 2006, we generated $4.7
      million net income from our operations. However, in 2002 and 2001 we h ad a
      net
      loss of $3.6 million and $15.0 million, respectively. The net loss in 2002
      and
      2001 was a reversal from prior years in which we had net income. The
      fluctuations in our net results are mainly attributable to the changes in the
      suite of modernization tools we have been offering to our customers, the limited
      experience we have had in the markets for these tools, the capital spending
      on
      information technology, and the difficulties we have encountered in introducing
      our tools to their respective markets. In addition, global economic conditions
      affect our net results. Most of the solutions we offer to our customers are
      based on tools that share a common generic technology and methodology. However,
      the introduction of new tools to new markets involves increased selling and
      marketing expenses, which in turn increases our operating expenses and directly
      affects our results of operations. Because of our limited experience in our
      principal markets and with our new products, we cannot assure you that our
      strategy for operating in these markets or selling these products will be
      successful. You should not rely on our historical results of operations as
      indications of future performance.





**If
      we are unable to accurately predict and respond to market developments or
      demands, our business will be adversely affected.**




The
      IT
      modernization business is characterized by rapidly evolving technology and
      methodologies. This makes it difficult to predict demand and market acceptance
      for our modernization tools and services. In order to succeed, we need to adapt
      the tools and services we offer to keep up with technological developments
      and
      changes in customer needs. We cannot guarantee that we will succeed in enhancing
      our tools and services or developing or acquiring new modernization tools and
      services that adequately address changing technologies and customer
      requirements. We also cannot assure you that the tools and services we offer
      will be accepted by customers. If our tools and services are not accepted by
      customers, our future revenues and profitability will be adversely affected.
      Changes in technologies, industry standards, the regulatory environment,
      customer requirements, and new product introductions by existing or future
      competitors could render our existing solutions obsolete and unmarketable,
      or
      require us to enhance our current tools or develop new tools. This may require
      us to expend significant amounts of money, time, and other resources to meet
      the
      demand. This could strain our personnel and financial resources.





**We
      may experience significant fluctuations in our annual and quarterly results,
      which makes it difficult to make reliable period-to-period comparisons and
      may
      contribute to volatility in the market price of our ordinary shares and
      convertible notes.**




Our
      quarterly and annual results of operations have fluctuated significantly in
      the
      past and we expect them to continue to fluctuate significantly in the future.
      These fluctuations are the result of risks related to the introduction of new
      products as described above and any of the following events:




5




· adverse
          economic conditions in various geographic areas where our customers and
          potential customers operate;


·  acquisitions
      and dispositions of companies;


·  timing
      of
      completion of specified milestones and delays in implementation;


·  timing
      of
      product releases;


·  timing
      of
      contracts;


· increases
          in selling and marketing expenses, as well as other operating expenses;
          and


· currency
      fluctuations and financial expenses related to our financial
      instruments.





In
      addition, unexpected events that do not occur on a regular basis and that are
      difficult to predict may cause fluctuations in our operating results. As a
      result, we believe that period-to-period comparisons of our historical results
      of operations are not necessarily meaningful and that you should not rely on
      them as an indication for future performance. Also, it is possible that our
      quarterly and annual results of operations may be below the expectations of
      public market analysts and investors.





**A
      delay in collection of our fees could result in cash flow shortages, which
      in
      turn may significantly impact our financial results.**





Typical
      modernization projects, which deploy our solutions, are long-term projects,
      and
      therefore, payment for these projects or a substantial portion of our fees
      may
      be delayed until the successful completion of specified milestones. In addition,
      the payment of our fees is dependent upon customer acceptance of the completed
      work, and our ability to collect the fees. Further, although the timing of
      receipt of our fees varies, we incur the majority of our expenses on a current
      basis. As a result, a delay in the collection of our fees could result in cash
      flow shortages. To date, we have not experienced any significant payment delays
      that resulted in cash flow shortages. Any significant variation in estimated
      and
      actual revenues obtained may significantly impact our financial results in
      any
      given period.





**Mainsoft’s
      dependency on Microsoft .NET, an open-source implementation of Microsoft, could
      have a material adverse effect on our business.**





Mainsoft’s
      Visual MainWin for J2EE has been developed based on the open-source Mono project
      led by Novell, which is an open-source implementation of the Microsoft .NET
      framework. Microsoft may claim that software developed based on the open-source
      Mono project infringes certain Microsoft patents. In addition, Microsoft may
      cease its business relationship and cooperation with companies using the open
      source Mono project, which may result in severe damage to Mainsoft’s ability to
      effectively market the Visual MainWin for J2EE product.





Damage
      to
      Mainsoft’s relationship with Microsoft could have a material adverse effect on
      our business, financial condition, and results of operations.





6


**If
        we fail to address the strain on our resources caused by changes in our company,
        we will be unable to effectively manage our business.**
 
 In
        the
        past few years, we have undergone significant changes in our product offerings.
        These changes include acquiring new technologies, developing and marketing
        new
        modernization and porting tools and expanding the sales of our products further
        into international markets. This has placed and will continue to place
        substantial demands upon our management, systems, and resources, including
        our
        sales, project management, consulting personnel, and software development
        operations. Our ability to manage any future changes or growth depends on
        our
        ability to continue to implement and improve our operational, financial,
        and
        management information control and reporting systems on a timely basis, and
        to
        expand, train, motivate, and manage our work force. If we cannot respond
        effectively to changing business conditions, our business, financial condition,
        and results of operations could be materially adversely affected.
 
 **If
        we are unable to manage the effects of the variations in our offering portfolio,
        our results will be adversely affected.**
 
 We
        specialize in the development and implementation of sophisticated software
        modernization and porting tools and products. We leverage our know-how,
        experience and generic technologies, to develop and introduce new software
        tools
        that enable the modernization of legacy systems. The need for our modernization
        solutions changes over time, and recent regulations or newly introduced
        technologies may create new needs for modernization solutions. As part of
        our
        growth strategy, as a new need evolves, we typically conduct a market analysis
        to qualify and quantify the market opportunity. If the results justify the
        investment required for the development of new products or tools, then we
        begin
        the development process of the new product. In order to maintain our position
        in
        the market, and our ability to address the constantly changing needs of the
        marketplace, we continually invest in the development of new products. The
        net
        annual expense related to research and development was $9.4 million in 2006,
        $8.0 million in 2005 and $8.1 million in 2004.
 
 In
        order
        to properly introduce a new product to the marketplace or to introduce our
        current products into new markets, we continuously update our marketing
        materials, educate our sales force and make changes to our operations. If
        these
        activities are not completed in a timely manner, our new product introduction
        may be delayed and our business, financial condition, and results of operations
        could be materially adversely affected.
 
 **If
        we are unable to attract, train, and retain qualified personnel for our
        worldwide facilities at competitive prices, we may not be able to achieve
        our
        objectives and our business could be harmed.**
 
 In
        order
        to achieve our objectives, we hire from time to time additional qualified
        software, administrative, operational, sales, and technical support personnel.
        The process of attracting, training, and successfully integrating qualified
        personnel can be lengthy and expensive. We may not be able to compete
        effectively for the personnel we need. As part of our growth strategy, we
        developed offshore centers in Cyprus and Romania. We hired professional
        consultants for these development centers, leveraging the lower employer
        costs
        that existed in these countries. Recently, professional work in these countries
        became more expensive and professional fees may continue to increase in the
        future. As a result, we may consider establishing alternative off-shore
        facilities in other countries. The establishment of additional off-shore
        facilities may result in significant capital expenses which may affect our
        cash
        position. We cannot assure you that our off-shore facilities will be profitable.
        Our future success depends on our ability to absorb and retain senior employees
        and to attract, motivate, and retain highly qualified professional employees
        worldwide at competitive prices.
  7
  **If
        we fail to estimate accurately the costs of fixed-price contracts, we may
        incur
        losses.**
 
 We
        derive
        a portion of our revenues from engagements on a fixed-price basis. We price
        these commitments upon estimates of future costs. We bear the risk of faulty
        estimates and cost overruns in connection with these commitments. Our failure
        to
        accurately estimate the resources required for a fixed-price project, to
        accurately anticipate potential wage increases, or to complete our contractual
        obligations in a manner consistent with the project plan could materially
        adversely affect our business, operating results, and financial condition.
        In
        addition, we may agree to a price before the design specifications are
        finalized, which could result in a fixed price that is too low, resulting
        in
        lower margins or losses to us.
 
 **If
        our tools or solutions do not function efficiently, we may incur additional
        expenses.**
 
 In
        the
        course of providing our modernization solutions, the project team conducts
        testing to detect the existence of failures, errors and bugs. If our
        modernization solutions fail to function efficiently or if errors or bugs
        are
        detected in our tools, we might incur significant expenditures in an attempt
        to
        remedy the problem. The consequences of failures, errors, and bugs could
        have a
        material adverse effect on our business, operating results, and financial
        condition.
 
 **If
        we fail to satisfy our customers’ expectations regarding our solutions, our
        contracts may be cancelled and we may be the subject of damages
        claims.**
 
 In
        the
        event that we fail to satisfy our customers’ expectations from the results of
        the implementation of our solutions, or if we fail to timely deliver our
        solutions to our customers, these customers may suffer damages. When
        and
        if this occurs, customers may have the ability to cancel our contracts. Any
        cancellation of a contract could cause us to suffer damages, since we might
        not
        be paid for costs that we incurred in performing services prior to the date
        of
        cancellation. In addition, f rom
        time
        to time we may be subject to claims as a result of not delivering our products
        on time or in a satisfactory manner. Such disputes or others may lead to
        material damages.
  8
  **We
        are exposed to significant claims for damage caused to our customers’
information systems.**
 
 Some
        of
        the products, tools, and services we provide involve key aspects of our
        customers’ information systems. These systems are frequently critical to our
        customers’ operations. As a result, our customers have a greater sensitivity to
        failures in these systems than do customers of other software products
        generally. We have never been the subject of a material damages claim related
        to
        our modernization solutions or modernization services. However, if a customer’s
        system fails during or following the provision of modernization solutions
        or
        services by us, or if we fail to provide customers with proper support for
        our
        modernization solutions, we are exposed to the risk of a claim for substantial
        damages against us, regardless of our responsibility for the failure. We
        cannot
        guarantee that the limitations of liability under our product and service
        contracts, if any, would be sufficient to protect us against legal claims.
        We
        cannot assure you that our insurance coverage will be sufficient to cover
        one or
        more large claims, or that the insurer will not disclaim coverage as to any
        future claim. If we lose one or more large claims against us that exceed
        available insurance coverage, it may have a material adverse effect on our
        business, operating results, and financial condition. In addition, the filing
        of
        legal claims against us in connection with contract liability may cause us
        negative publicity and damage to our reputation.
 
 **If
        third parties assert claims of infringement against us, we may suffer
        substantial costs and diversion of management’s attention.**
 
 Substantial
        litigation over intellectual property rights exists in the software industry.
        Software products may be increasingly subject to third-party infringement
        claims
        as the functionality of products in different industry segments overlaps.
        Although our products and services have never been the subject of an
        infringement proceeding, we cannot predict whether third parties will assert
        claims of infringement against us. In addition, our employees and contractors
        have access to software licensed by us from third parties. A breach of the
        nondisclosure undertakings by any of our employees or contractors may lead
        to a
        claim of infringement against us. Any claim, with or without merit, could
        be
        expensive and time-consuming to defend, and would probably divert our
        management’s attention and resources. In addition, such a claim if submitted may
        require us to enter into royalty or licensing agreements to obtain the right
        to
        use a necessary product or component. Such royalty or licensing agreements,
        if
        required, may not be available to us on acceptable terms, if at
        all.
 
 A
        successful claim of product infringement against us and our failure or inability
        to license the infringed or similar technology could have a material adverse
        effect on our business, financial condition, and results of
        operations.
 
 **We
        may be unable to adequately protect our proprietary rights, which may limit
        our
        ability to compete effectively.**
 
 Our
        success and ability to compete are substantially dependent upon our internally
        developed technology. Our intellectual property consists of proprietary or
        confidential information that is not subject to patent or similar protection.
        Our employees and contractors have direct access to our technology. In general,
        we have relied on a combination of technical leadership, trade secret,
        copyright, and trademark law and nondisclosure agreements to protect our
        proprietary know-how. Unauthorized third parties may attempt to copy or obtain
        and use the technology protected by those rights. Any infringement of our
        intellectual property could have a material adverse effect on our business,
        financial condition, and results of operations. Policing unauthorized use
        of our
        products is difficult and costly, particularly in countries where the laws
        may
        not protect our proprietary rights as fully as in the United States.
  9
  Pursuant
        to agreements with certain of our customers, we have placed, and in the future
        may be required to place, in escrow, the source code of certain of our software.
        Pursuant to the escrow arrangements, the software may, under specified
        circumstances, be made available to our customers. From time to time, we
        also
        provide our software directly to customers. These factors may increase the
        likelihood of misappropriation or other misuse of our software.
 
 **We
        are exposed to litigation that could result in considerable financial
        liabilities.**
 
 In
        July
        2003, a former Liraz shareholder filed an application with the Tel-Aviv-Jaffa
        District Court to approve a claim filed by him against us, as a class action.
        The claim relates to the acquisition of Liraz shares, which we completed
        in
        March 2003. The shareholder alleges that the share price we paid to Liraz’s
        shareholders in the tender offer and in a subsequent mandatory purchase was
        lower than the fair price of Liraz shares. The maximum amount of the claim
        is
        approximately NIS 30.5 million ($7.3 million) in the aggregate. Under Israeli
        law, the court’s approval is required for the plaintiff to represent all of the
        shareholders of Liraz who sold their shares to us pursuant to the tender
        offer
        and the mandatory acquisition. The plaintiff has applied for such approval
        in
        the lawsuit. If we are not successful in defending this claim, we could be
        exposed to considerable financial liabilities and, as a result, our financial
        condition could be materially adversely harmed.
 
 **Our
        largest shareholder, Formula, controls a majority of our ordinary shares
        and
        influences the outcome of matters that require shareholder
        approval.**
 
 Formula
        Systems (1985) Ltd., referred to as Formula, owns, as of March 22, 2007,
        52.3%
        of our outstanding ordinary shares. Therefore, Formula has the power to control
        the outcome of most matters requiring shareholder approval, including the
        election of directors and approval of significant corporate transactions.
        Gad
        Goldstein, the chairman of our board, and president and chief executive officer
        of Formula, directly owns 230,628 ordinary shares, representing 1.5% of our
        outstanding ordinary shares. Gad Goldstein owns 2.5% of the outstanding shares
        of Formula.
 
 This
        share ownership may have the effect of delaying or preventing a change in
        control. Although Israeli law imposes certain procedures (including shareholder
        approval) for approval of certain related party transactions, including certain
        of those between us and Formula, we cannot assure you that these procedures
        will
        eliminate the possible detrimental effects of conflicts of interest. If certain
        transactions are not approved in accordance with required procedures under
        applicable Israeli law, these transactions may be void or voidable.
 
 **Our
        existing credit facilities contain a number of restrictions and obligations
        that
        limit our operating and financial flexibility.**
 
 Our
        credit facilities contain a number of restrictive covenants that limit our
        operating and financial flexibility. These covenants, among other things,
        restrict our ability to pledge our assets, dispose of assets, make loans
        or give
        guarantees, make certain acquisitions and engage in mergers or consolidations.
        Our credit facilities also contain covenants regarding maintaining certain
        financial ratios. See “Item 5.B. Liquidity and Capital Resources – How We Have
        Financed Our Business.”
  10
  Our
        ability to continue to comply with these and other obligations depends in
        part
        on the future performance of our business. There can be no assurance that
        such
        obligations will not materially adversely affect our ability to finance our
        future operations or the manner in which we operate our business. In particular,
        any noncompliance with performance-related covenants and other undertakings
        of
        our credit facilities could result in an acceleration of our outstanding
        debt
        under our credit facilities and restrict our ability to obtain additional
        funds,
        which could have a material adverse effect on our business, financial condition
        and results of operations.
 
 In
        some
        circumstances, a change of control of BluePhoenix will constitute an event
        of
        default under our credit facilities and we could be required to repay our
        debts
        to the banks. If this occurs, we may not have the financial resources to
        repay
        all of our outstanding debt. This also may adversely affect the attractiveness
        of our company to potential large investors.
 
 **Our
        failure to fulfill our obligations under our credit facility agreements,
        convertible debentures or other financial arrangements will adversely affect
        our
        cash flow, cash position and net results.**
 
 We
        intend
        to fulfill our debt service obligations from existing cash, investments and
        our
        operations. Our failure to fulfill our obligations under our credit facilities,
        the convertible debentures or our other financial arrangements, will have
        significant negative consequences, including, without limitation:
 
 ·
              requiring
                  the dedication of a portion of our expected cash flow to service
                  our
                  indebtedness, thereby reducing the amount of our expected cash
                  flow
                  available for other purposes, including funding our research and
                  development programs and other capital
                  expenditures;
 ·
              increasing
                  our vulnerability to general adverse economic
                  conditions;
 ·
              limiting
                  our ability to obtain additional financing;
 ·
              placing
                  us at a possible competitive disadvantage relative to less leveraged
                  competitors and competitors that have better access to capital
                  resources;
                  and
 ·
              causing
                  a material offset to our results, resulting decreased net profits
                  or
                  increased net losses.
 
 **We
        may not be able to make our debt payments in the future.**
 
 Our
        ability to meet our debt obligations will depend on whether we can successfully
        implement our strategy, as well as on financial, competitive, and other factors,
        including some factors that are beyond our control. Most of our debt and
        credit
        facilities bear an interest rate based on the LIBOR. If the LIBOR materially
        increases, our cash flows will be negatively affected. If we are unable to
        generate sufficient cash flow from operations to meet principal and interest
        payments on our debt, we may have to refinance all or part of our indebtedness.
        In case we have to increase our indebtedness, the additional financing expenses
        will have a negative affect on our results, which cannot be predicted. Our
        ability to refinance our indebtedness will depend on, among other
        things:
 
 ·
              our
                  financial condition at the time;
  11
  ·
              restrictions
                  in agreements governing our debt;
                  and
 ·
              other
                  factors, including market
                  conditions.
 
 We
        cannot
        ensure that any such refinancing would be possible on terms that we could
        accept
        or that we could obtain additional financing. If refinancing will not be
        possible or if additional financing will not be available, we may have to
        sell
        our assets under circumstances that might not yield the highest prices, or
        default on our debt obligations, which would permit our noteholders and holders
        of other outstanding indebtedness to accelerate their maturity dates. If
        we
        incur additional debt or liabilities, our ability to pay our debt obligations
        could be adversely affected.
  ***Risks
        Relating to International Operations***
  **Marketing
        our tools and solutions in international markets may cause increased expenses
        and greater exposure to risks that we may not be able to successfully
        address.**
 
 We
        intend
        to continue to expand our international operations, which will require
        significant management attention and financial resources. In order to continue
        to expand worldwide sales, we need to establish additional marketing and
        sales
        operations, hire additional personnel, and recruit additional resellers
        internationally. To the extent that we are unable to do so effectively, our
        growth is likely to be limited and our business, operating results and financial
        condition will be materially adversely affected.
 
 Risks
        inherent in our worldwide business activities generally include:
 
 ·
              currency
                  exchange devaluations;
 ·
              unexpected
                  changes in regulatory requirements;
 ·
              tariffs
                  and other trade barriers;
 ·
              costs
                  of localizing products for foreign
                  countries;
 ·
              lack
                  of acceptance of localized
                  products.;
 ·
              longer
                  accounts receivable payment cycles;
 ·
              difficulties
                  in operations of management;
 ·
              potentially
                  adverse tax consequences, including restrictions on the repatriation
                  of
                  earnings; and
 ·
              the
                  burdens of complying with a wide variety of local legislation.
 
 We
        cannot
        assure you that these factors will not have a material adverse effect on
        our
        future international sales and, consequently, on our business, operating
        results
        and financial condition.
  12
  **Inflation,
        devaluation and fluctuation of various currencies may adversely affect our
        results of operations, liabilities and assets.**
 
 We
        run
        our operations in various countries. As a result, we enter into transactions
        with customers and suppliers in local currencies. The fluctuations in foreign
        currency exchange rates in countries where we operate can adversely affect
        the
        reflection of these activities in our consolidated financial statements.
        Fluctuations in the value of our non-dollar revenues, costs and expenses
        measured in dollars could materially affect our results of operations. In
        addition, our balance sheet reflects non-dollar denominated assets and
        liabilities, which can be adversely affected by fluctuations in the currency
        exchange rates.
 
 The
        reporting currency of our consolidated financial statements is the U.S. dollar.
        The functional currency of our business is the U.S. dollar. We enter, from
        time
        to time, into forward currency exchange contracts or other arrangements in
        order
        to hedge this foreign currency exposure. Such arrangements may not always
        be
        effective or sufficient to offset the fluctuations in currency exchange rates. For
        additional information relating to the exchange rates between different relevant
        currencies, see “Item 5. – Our Reporting Currency.”
 
 **Fluctuations
        in foreign currency values affect the prices of our products, which in turn
        may
        affect our business and results of operations.**
 
 Most
        of
        our worldwide sales are currently denominated in U.S. dollars and euros while
        our reporting currency is the dollar. A decrease in the value of the dollar
        relative to foreign currencies, in particular the euro, Danish kroner (DKK)
        and
        the NIS would make our products more expensive and increase our operating
        costs
        and, therefore, could adversely affect our results and harm our competitive
        position in the markets in which we compete.
 
 **We
        are subject to multiple taxing jurisdictions. If we fail to estimate accurately
        the amount of income tax due in any of these jurisdictions, our net income
        might
        be affected.**
 
 We
        operate within multiple taxing jurisdictions and are subject to taxation
        by
        these jurisdictions at various tax rates. In addition, we may be subject
        to
        audits in these jurisdictions. These audits can involve complex issues, which
        may require an extended period of time to resolve. We cannot assure you that
        the
        final tax outcome of these issues will not be different than management
        estimates, which are reflected in our income tax provisions. Such differences
        could have a material effect on our income tax provision and net income in
        the
        period in which such outcome occurs.
  13
  ***Risks
        Relating to Operations in Israel***
 
 **Political,
        economic, and military conditions in Israel could negatively impact our
        business.**
 
 Over
        the
        past several decades, a number of armed conflicts have occurred between Israel
        and its Arab neighbors. Any hostilities involving Israel or the interruption
        or
        curtailment of trade between Israel and its present trading partners could
        affect our operations. Since September 2000, there has been a marked increase
        in
        violence, civil unrest and hostility, including armed clashes between the
        State
        of Israel and the Palestinian Authority and other groups in the West Bank
        and
        Gaza Strip, and acts of terror have been committed inside Israel and against
        Israeli targets in the West Bank and Gaza. During July and August 2006, major
        hostilities broke out between Israel and both Palestinian factions in Gaza
        and
        Hezbollah in Lebanon, leading to an escalation of the conflict in the area.
        Major towns and settlements in northern Israel, including Haifa, Naharia,
        Safed
        and Karmiel, were under attack from Hezbollah missiles. Such conflicts, as
        well
        as the execution of Israel’s plan of unilateral disengagement from the Gaza
        Strip and some parts of the West Bank and Hamas’ gaining majority of the
        Palestinian Parliament in the elections held in 2006, may affect Israel’s
        security, foreign relations and the stability of the region. Increased
        hostilities, future armed conflicts, political developments in other states
        in
        the region, or continued or increased terrorism could make it more difficult
        for
        us to conduct our operations in Israel, which could increase our costs and
        adversely affect our financial results. In addition, many of our male employees
        in Israel are obligated to perform annual military reserve duty typically
        until
        45 years of age and in some cases up to 54 years of age, and are subject
        to
        being called for active duty under emergency circumstances. While we have
        operated effectively under these requirements since our incorporation, we
        cannot
        predict the full impact of such conditions on us in the future, particularly
        if
        emergency circumstances occur. If many of our employees are called for active
        duty, our operations in Israel and our business may be adversely
        affected.
  **It
        may be difficult to serve process and enforce judgments against our directors
        and officers in Israel.**
  We
        are
        organized under the laws of the State of Israel. Most of our executive officers
        and directors are nonresidents of the United States, and a substantial portion
        of our assets and the assets of these persons are located outside the United
        States. Therefore, it may be difficult to:
  ·
              effect
                  service of process within the United States on us or any of our
                  executive
                  officers or directors who are nonresidents of the United
                  States;
 ·
              enforce
                  court judgments obtained in the United States including those predicated
                  upon the civil liability provisions of the United States federal
                  securities laws, against us or against any of our executive officers
                  or
                  directors that are nonresidents of the United States, in the United
                  States
                  or Israel; and
 ·
              bring
                  an original action in an Israeli court against us or against any
                  of our
                  executive officers or directors to enforce liabilities based upon
                  the
                  United States federal securities
                  laws.
  14
  ***Risks
        Related to our Traded Securities***
 
 **The
        market price of our convertible notes and ordinary shares may be volatile
        and
        our investors may not be able to resell the notes or the shares at or above
        the
        price they paid, or at all.**
 
 During
        the past few years, the worldwide stock markets have experienced high price
        and
        volume fluctuations. The market prices of securities of technology companies
        have been extremely volatile, and have experienced fluctuations that have
        often
        been unrelated or disproportionate to the operating performance of those
        companies. These broad market fluctuations could adversely affect market
        price
        of our ordinary shares. The high and low market price of our ordinary shares
        traded on the Nasdaq Global Market and the Tel Aviv Stock Exchange, or the
        TASE,
        during each of the last three years, are summarized in the table
        below:
 
 **Nasdaq Global Market**
              
              **TASE****In $**
              
              **In NIS****High**
              
              **Low**
              
              **High**
              
              **Low****2006**
              
              
              6.45
              
              
              3.85
              
              
              18.30
              
              
              28.99**2005**
              
              
              4.75
              
              
              3.81
              
              
              21.95
              
              
              16.01**2004**
              
              
              7.49
              
              
              3.71
              
              
              33.80
              
              
              17.00
 
 The
        market price of our ordinary shares may continue to fluctuate substantially
        due
        to a variety of factors, including:
 
 ·
              any
                  actual or anticipated fluctuations in our or our competitors’ quarterly
                  revenues and operating results;
 ·
              shortfalls
                  in our operating results from levels forecast by securities
                  analysts;
 ·
              public
                  announcements concerning us or our
                  competitors;
 ·
              the
                  introduction or market acceptance of new products or service offerings
                  by
                  us or by our competitors;
 ·
              changes
                  in product pricing policies by us or our
                  competitors;
 ·
              changes
                  in security analysts’ financial
                  estimates;
 ·
              changes
                  in accounting principles;
 ·
              sales
                  of our shares by existing shareholders;
                  and
 ·
              the
                  loss of any of our key personnel.
 
 In
        addition, economic, political, and market conditions and military conflicts
        and,
        in particular, those specifically related to the State of Israel, may affect
        the
        market price of our shares.
  15
  In
        February 2006, we completed an underwritten public offering in Israel of
        series
        A convertible notes, referred to in this annual report as the convertible
        notes,
        in an aggregate principal amount of NIS 54.0 million that were equal at that
        time to approximately $11.5 million. Following the offering, the convertible
        notes have been listed for trading on the TASE. The
        trading price of the convertible notes depends on many factors, including
        but
        not limited to, prevailing interest rates, the trading price of our ordinary
        shares, the market for similar securities and general economic conditions.
        Therefore, the trading price of the convertible notes could be subject to
        significant fluctuations. Additionally, it is possible that the market for
        the
        convertible notes will be subject to disruptions that may have a negative
        effect
        on the holders of the convertible notes, regardless of our prospects or
        financial performance. During 2006, the market price of our convertible notes
        traded on the TASE, fluctuated between NIS 1.06 and NIS 1.02.
 
 **Our
        ordinary shares are traded on more than one market and this may result in
        price
        variations.**
 
 Our
        ordinary shares trade on the NASDAQ Global Market and the TASE. Trading in
        our
        ordinary shares on these markets take place in different currencies (dollars
        on
        the NASDAQ Global Market and NIS on the TASE), and at different times (resulting
        from different time zones, different trading days and different public holidays
        in the United States and Israel). The trading prices of our ordinary shares
        on
        these two markets may differ due to these and other factors. Any decrease
        in the
        trading price of our ordinary shares on one of these markets could cause
        a
        decrease in the trading price of our ordinary shares on the other
        market.
  **Future
        sales of our shares to be registered for resale in the public market, as
        well as
        conversion of our convertible securities, could dilute the ownership interest
        of
        our existing shareholders and could cause the market price for our ordinary
        shares or convertible notes to fall.**
  As
        of
        March 22, 2007, we had 15,374,124 ordinary shares outstanding (excluding
        1,647,594 held by two of our wholly owned subsidiaries). In addition, we
        reserved 2,145,017 ordinary shares for issuance under our option plans. We
        also
        have certain commitments described below to issue BluePhoenix ordinary shares
        and register them for resale, as follows:
 
 ·
              691,105
                  ordinary shares issuable upon conversion of debentures issued to
                  institutional investors in connection with the $5 million private
                  placement completed in March 2004;
 
 ·
              485,714
                  ordinary shares issuable upon exercise of warrants issued to institutional
                  investors in connection with the $5 million and $3 million private
                  placements, completed in March 2004 and March 2006, respectively;
                  and
 
 ·
              2,059,064
                  ordinary shares issuable upon conversion of the convertible notes
                  traded
                  on the TASEsold
                  by us in a public offering in Israel in February 2006.
 
 For
        information about the debentures and the warrants issued to the institutional
        investors, see “Item 5.B Liquidity and Capital Resources – Contractual
        Commitments and Guarantees.”
  16
  The
        conversion of some or all of the convertible debentures held by the
        institutional investors, the exercise of options and warrants held by investors,
        and the conversion of the convertible notes traded on the TASE, would dilute
        the
        ownership interests of our existing shareholders. Any sales in the public
        market
        of our ordinary shares issuable upon such conversion could adversely affect
        the
        prevailing market prices of our ordinary shares.
 
 In
        addition, certain of our shareholders, holding in the aggregate 9,655,663
        ordinary shares, have registration rights with respect to the shares they
        hold,
        including piggyback rights. For
        more
        information about these rights, see “Item 7.B Related Party Transactions –
Registration Rights Agreements.”
 
 If
        a
        large number of our ordinary shares are sold in a short period, the price
        of our
        ordinary shares would likely decrease.
 
 In
        addition, the price of our ordinary shares could be affected by possible
        sales
        of our ordinary shares by investors who view the convertible notes as a more
        attractive means of equity participation in our company and by hedging or
        arbitrage trading activity that may develop involving our ordinary shares.
        The
        hedging or arbitrage could, in turn, affect the trading price of the convertible
        notes.
 
 **We
        may be characterized as a passive foreign investment company, or PFIC, for
        U.S.
        federal income tax purposes.**
 
 If,
        for
        any taxable year, our passive income or assets that produce passive income
        exceed levels provided by law, we may be characterized as a PFIC for U.S.
        federal income tax purposes. This characterization could result in adverse
        U.S.
        tax consequences to U.S. holders of ordinary shares. If we were classified
        as a
        PFIC, a U.S. holder of ordinary shares could be subject to increased tax
        liability upon the sale or other disposition of ordinary shares or upon the
        receipt of amounts treated as “excess distributions.” United States holders
        should consult with their own U.S. tax advisors with respect to the tax
        consequences of investing in our ordinary shares as well as the specific
        application of the PFIC rules. For a more detailed discussion, see
“Taxation—United States Federal Income Tax Considerations — Tax
        Consequences if We Are a Passive Foreign Investment Company.”
  **ITEM
        4. INFORMATION ON THE COMPANY**
  **A.**  **History
        and Development of the Company**
  We
        were
        incorporated in Israel in 1987 under the name A. Crystal Solutions Ltd. In
        1996,
        we changed our name to Crystal Systems Solutions Ltd. In 2003, following
        the
        acquisition of Liraz Systems Ltd., we changed our name to BluePhoenix Solutions
        Ltd. Our registered office is located at 8 Maskit Street, Herzlia, 46120
        Israel
        and our telephone number is 972-9-9526110. Our agent in the United States
        is **** Blue
        Phoenix Solutions USA Inc., 8000 Regency Parkway, Cary, NC 27511 United States
        and its telephone number is (919) 380-5100.
  17
  We
        run
        our worldwide operations through several wholly owned subsidiaries, named
        below:
 
 **Name of Subsidiary**
              
              **Country of Incorporation**BluePhoenix
                  Solutions USA Inc.
              
              
              United
                  StatesIntraComp
                  Group Inc.
              
              
              Unites
                  StatesBluePhoenix
                  Solutions Nordic ApS
              
              
              DenmarkBluePhoenix
                  Solutions U.K. Ltd.
              
              
              United
                  KingdomBluePhoenix
                  Solutions Srl.
              
              
              ItalyI-Ter/Informatica
                  & Territorio S.p.A.
              
              
              ItalyBluePhoenix
                  Solutions GmbH
              
              
              GermanyBluePhoenix
                  Solutions B.V.
              
              
              The
                  NetherlandsBluePhoenix
                  Solutions Ltd.
              
              
              CyprusBluePhoenix
                  Solutions Srl.
              
              
              Romania
 
 For
        information about our significant subsidiaries, see “Item 4.C. Organizational
        structure.”
 
 ***Recent
        Developments***
 
 In
        December 2006, we acquired from CodeStream Software Ltd., or CodeStream,
        a key
        competitor in providing IDMS database migrations, certain business assets
        and
        activities in the field of modernization of legacy databases. The acquired
        activities enable us to provide IDMS modernization products and services,
        enabling organizations to move their IDMS systems to modern relational databases
        serving modern web based applications on Java, Microsoft .NET or COBOL
        technology platforms. Pursuant to the purchase agreement, we hired 18 persons
        previously employed by CodeStream and assumed all the obligations in respect
        of
        the purchased activities. In consideration for the acquisition of CodeStream’s
        assets and activities, we paid to CodeStream **₤** 5.2
        million (approximately $10.2 million). We believe that this acquisition
        strengthens our position as a leading provider in the market of database
        and
        application migrations **.**
  **B.**  **Business
        Overview**
  ***Our
        Business***
  We
        develop and market unique value driven enterprise IT modernization, or EIM,
        solutions that enable companies to automate the process of modernizing and
        upgrading their mainframe and distributed IT infrastructure in order to more
        effectively compete in today’s business environment. The combination of our
        comprehensive tools and services with our unique methodology provides an
        efficient and cost-effective process for extending the return on investment
        of
        existing enterprise IT assets. Our complete modernization solutions consist
        of a
        combination of automated technologies and services that minimize the risk
        through the whole life cycle of the modernization process. Our solutions
        are
        based on technologies that support the four phases of the process, which
        we
        call: Understanding, Migration, Remediation, and Redevelopment. The solutions
        allow companies to fully leverage their current systems and applications,
        speed
        up and reduce the cost of the renewal process, and effectively update their
        systems in order to adapt to new business demands. In addition, by using
        our
        technologies our customers gain the added value of extending their systems
        to be
        ready for future demands, such as service oriented architecture, or SOA.
        Our
        modernization solutions are offered to customers in all business market sectors,
        particularly financial services, automotive and governmental entities. In
        addition, we provide consulting services such as application development
        services and maintenance for core banking systems.
  18
  Our
        solution portfolio includes software products, software tools, and services
        that
        address the most pressing IT challenges which organizations and companies
        face
        today, including:
 
 ·
              lack
                  of agility and responsiveness to changing business
                  needs;
 ·
              difficulty
                  in recruiting and retaining mainframe
                  professionals;
 ·
              growing
                  cost of software licenses, maintenance and operations;
 ·
              lack
                  of packaged software and new applications;
                  and
 ·
              difficulties
                  in complying with new regulations.
 
 Our
        solutions enable companies to:
 
 ·
              effectively
                  plan and carry out strategic projects that provide real business
                  value;
 ·
              better
                  understand and manage their IT systems and
                  resources;
 ·
              easily
                  integrate packaged applications and build customized
                  applications;
 ·
              significantly
                  decrease maintenance, human resource, and technology costs;
 ·
              quickly
                  migrate to modern databases, platforms, applications, and programming
                  languages with a proven suite of tools and
                  services;
 ·
              substantially
                  transform applications and databases in order to address regulatory
                  and
                  business changes; and
 ·
              directly
                  gain access to cutting edge technology and new business
                  channels.
 
 Our
        comprehensive enterprise technologies span mainframe, midrange, and
        client/server computing platforms. We have enhanced our expertise through
        the
        successful completion of projects for many large organizations over the past
        two
        decades, establishing our credibility and achieving international recognition
        and presence. Based on our technology and that of our affiliates, we develop
        and
        market software products, tools, and related methodologies. We deliver our
        tools
        and methodologies together with training and support in order to provide
        enterprises with comprehensive solutions, primarily for the modernization
        of
        existing IT systems.
  ***Market
        Background***
  Companies
        initiate IT modernization projects for a wide range of reasons, such
        as:
 
 ·
              maintaining
                  a competitive edge in the market;
 ·
              addressing
                  changing business needs;
 ·
              complying
                  with new regulations;
  19
  ·
              reducing
                  maintenance, human resources, and technology costs;
                  or
 ·
              gaining
                  access to cutting edge technology and new business
                  channels.
 
 Alternatives
        to modernization, include, among others, renewing legacy systems, buying
        packaged software, or rebuilding entire applications. Enterprise IT
        modernization has proven to be the most efficient and viable way for companies
        to protect their existing investments. We provide a range of solutions designed
        to efficiently address the challenge of retaining the business knowledge
        built
        into the application code while updating the system to reflect new
        requirements.
 
 The
        EIM
        market is divided into the following categories:
 
 *Enterprise
        IT Understanding* —These
        solutions enable companies to make informed strategic decisions regarding
        the
        future of their IT systems by automatically capturing multiple levels of
        operational and development information into a consolidated metadata warehouse.
        Our tools facilitate global assessments and impact analyses of application
        assets, thus helping reduce costs, streamline working processes, and increase
        efficiency.
 
 *Enterprise
        IT Migration* —These
        solutions enable companies to consolidate and eliminate a wide range of legacy
        hardware and software through automated migration of applications, databases,
        platforms, programming languages, and data. These tools help to reduce costs
        and
        resources, and minimize reliance on proprietary technology, sunset products,
        and
        dwindling skill sets. Our SOA-ready solution is provided as a post-migration
        service, allowing customers to extend their development environment by providing
        access to mainframe systems through Web services protocols, making legacy
        systems appear as modern systems.
 
 *Enterprise
        IT Remediation* —These
        solutions enable companies to extend the life of their existing IT systems
        by
        quickly adapting to new regulatory changes and business requirements. These
        automated tools can be easily customized to fit any IT environment and corporate
        need, including data field adjustment, IT standardization, and system
        consolidation.
 
 *Enterprise
        IT Redevelopment* —These
        solutions enable companies to mine existing applications by extracting business
        rules, data flows, and data models, and then re-using the proven code base
        to
        create more flexible Java/Web-based applications. Our tools help to reduce
        maintenance costs and resources and application development
        time-to-market.
 
 ***Enterprise
        IT Understanding***
 
 In
        the
        current lean budgetary environment, companies that want to extend the return
        on
        investment of their existing systems need to modernize their legacy systems.
        Since modernization projects are intricate and complex, the essential first
        step
        is a thorough review of existing IT assets.
 
 Our *understanding* solutions provide automated, detailed mapping of system-wide IT activity
        and the
        interconnections between all software components. This detailed road map
        serves
        as the basis for optimizing the re-use of existing IT systems, tailoring
        the
        modernization plan for the company’s unique IT environment and corporate
        requirements, and reducing future ongoing maintenance costs.
  20
  Modernization
        initiatives that need to be based on an in-depth examination of actual system
        elements include:
 
 ·
              building
                  and rewriting enterprise-scale application
                  components;
 ·
              implementing
                  new technologies such as
                  Web-enablement;
 ·
              integrating
                  purchased and newly written
                  applications;
 ·
              consolidating
                  servers and applications;
 ·
              migrating
                  to more modern platforms, databases and
                  languages;
 ·
              transforming
                  current applications to adapt to changing business standards;
                  and
 ·
              protecting
                  against the loss of critical personnel and corporate knowledge
                  base.
 
 Our
        integrated set of *enterprise
        IT understanding* solutions are designed to assist companies in achieving these goals by
        accurately mapping raw IT operational and development data, down to the program
        code level, into a consolidated enterprise-wide warehouse. The gathered
        information enables companies to keep track of system inventories, resources,
        and interrelationships and to intelligently mine systems and application
        metadata.
 
 This
        enterprise-wide view can then be used for a variety of strategic purposes,
        including:
 
 ·
              performing
                  impact, cost, and trend analyses as well as ongoing tracking of
                  IT
                  resources, inventories, components, their usage and their
                  interrelationships;
 ·
              running
                  business-logic analyses for business process identification, evaluation,
                  extraction, transition and
                  enhancement;
 ·
              achieving
                  significant cost reductions through the elimination of unused products,
                  unnecessary software upgrades, inefficient storage allocations,
                  and
                  wasteful CPU usage; and
 ·
              providing
                  more efficient application development by reusing systems and leveraging
                  existing business rules.
 
 *BluePhoenixTM
        IT Discovery* —This
        solution provides fast and convenient access to application inventory,
        dependency, and operational information. This tool performs the complete
        audit
        necessary to enable companies to define and analyze all application assets
        in
        order to make informed decisions about ongoing modernization activities. *IT Discovery* provides
        the ability to analyze on a refreshable basis numerous technology environments,
        and from them extract and report on the interrelationships among the components
        that make up these environments. In this manner, it provides an organization
        the
        ability to discover information about its current systems, thereby insuring
        that
        ongoing decisions are made based on an accurate audit of the current
        environment.
 
 *BluePhoenixTM
        LogicMiner* —This
        recovery solution mines COBOL and extracts business rules from the legacy
        code,
        thus providing IT departments with the ability to begin a modernization process
        based on techniques that preserve the functionality of legacy code. This
        tool
        retains past investments in software assets by producing reusable code objects
        or descriptive data that can later be used for improving the quality of the
        legacy code, rewriting the legacy application, or building a full modernization
        plan. LogicMiner increases a system’s manageability, while eliminating rules
        that no longer apply to current business procedures.
  21


***Enterprise
        IT Migration***
 
 Our
        comprehensive, integrated set of *enterprise
        IT migration* solutions enable companies to standardize and consolidate their IT systems
        by
        automatically converting and redeploying applications, databases, platforms,
        programming languages and data that are implemented on outdated computing
        platforms.
 
 Buying
        a
        packaged application or rebuilding one can often be an expensive and risky
        proposition. Therefore, companies often look towards migrating their existing
        applications. This option is much more cost-effective and time-efficient
        as it
        leverages their existing investments in custom applications. Additionally,
        our
        migration solutions enable companies to operate their IT systems independently,
        without relying on previous technology support providers. Thus, the migration
        process provides significant cost savings on development, maintenance, and
        human
        resources.
 
 Our
        migration solutions provide numerous advantages, including:
 
 ·
              significantly
                  decreasing project costs, risk of errors and
                  time;
 ·
              preserving
                  corporate business knowledge;
 ·
              substantially
                  reducing dependency on scarce skill
                  sets;
 ·
              solving
                  problematic maintenance issues;
 ·
              enabling
                  end-to-end project control and
                  management;
 ·
              directly
                  supplying a full audit trail and documentation of all
                  changes;
 ·
              minimizing
                  system freeze time with a unique “refresh” feature;
                  and
 ·
              comprehensively
                  working with most mainframe and non-mainframe
                  platforms.
 
 The *enterprise
        IT*  *migration* suite
        includes the following solutions:
 
 *BluePhoenixTM
        DBMSMigrator—* An
        automated migration tool that converts applications from nonrelational
        databases, such as IDMS (Integrated Database Management System), ADABAS,
        IMS,
        and VSAM, to relational databases, such as DB2, Oracle, and SQL Server. The
        tool
        performs automated conversions that provide companies with fully functional
        compliance for source and target applications and minimal application,
        functional, and logical program flow changes. *DBMSMigrator* leaves
        no residuals, emulation software, or translation procedures and allows system
        support to continue uninterrupted during the migration project. As a result
        of
        the conversion process, the migrated application operates more efficiently,
        is
        easier to maintain, and contains complete documentation of the customer’s
        knowledge base and guidelines.
 
 *BluePhoenixTM
        PlatformMigrator—* An
        automated migration tool that converts ** a
        range
        of platforms, including VSE, MVS, and Bull GCOS, to Unix, Linux, Windows,
        and
        .Net. *PlatformMigrator* can
        be ** customized
        to fit the unique IT configuration and business rules of each customer site.
        The
        tool converts platforms to a pure, native installation so that programs are
        not
        required to run under emulation or through translation techniques. *PlatformMigrator* solutions assist companies with maintaining service levels, setting and
        upgrading standards, implementing the new IT environment, training IT users,
        implementing new facilities like a security system or a batch scheduler,
        and
        testing for functional equivalence.
 
 22
 
 *BluePhoenixTM
        Rehosting—* Organizations
        implement mainframe rehosting in order to reduce the ongoing costs of existing
        legacy CICS and batch applications. Rehosting leverages the strength and
        investment of older COBOL applications while taking advantage of new,
        cost-efficient hardware and open operating system environments such as Linux,
        Unix, Windows, J2EE, and .NET.
 
 Using
        our
        various automated migration tools, and cooperating with our partners, we
        offer
        COBOL migration and mainframe rehosting solutions. We formed the following
        alliances for providing these solutions:
 
 ·
              a
                  cooperation withMicro
                  Focusfor implementing their “Lift and Shift” strategy. Micro Focus is a member
                  of theMigration
                  and Transformation Consortium (MTC)for COBOL solutions;
 ·
              an
                  alliance with Clerity for assisting companies to rehost mainframe
                  applications on more cost-efficient, open platforms;
                  and
 ·
              a
                  collaboration withFujitsufor assisting companies to migrate COBOL/CICS applications intoFujitsu
                  NetCOBOLand the Fujitsu NeoKicks and NeoBatch environments for handing
                  CICS and
                  batch/JCL.
 
 *BluePhoenixTM
        LanguageMigrator—* An
        automated migration tool for converting COBOL and 4GLs (fourth generation
        languages) such as ADSO, Natural, ALLFusion Gen (formerly COOL: Gen), Mantis,
        and PowerBuilder to COBOL and Java/J2EE. This reliable, time-efficient, and
        comprehensive solution enables site-wide installation, simultaneous testing,
        and
        implementation of batch programs. In addition, *LanguageMigrator* identifies the compatibility of the code, converts it to the new standards
        required by customers, and analyzes converted programs to identify potential
        problems. For more information about future developments of this tool, see
        “Research and Development.”
 
 *BluePhoenixTM
        DataMigrator—* A
        Windows-based tool for migrating data between various data system environments.
        Coupled with a step-by-step proven methodology, the tool provides a fully
        structured but still versatile automated data migration process. *DataMigrator* enables
        full control of source and target data definitions resulting in consistent,
        accurate, highest quality target data with no data loss, and efficient
        utilization of available resources. In addition, it provides support for
        partial
        or incremental migration and for multiple runtime environments.
 
 *BluePhoenixTM
        SOA-Ready Enablement* —This
        post-migration service extends the useful life of valuable legacy applications
        that run on historic mainframe platforms by allowing them to be easily reused
        in
        a modern Web-centric environment. This comprehensive solution provides Web
        services and Web customers for legacy applications. This unique set of tools
        enables the exposure of a legacy application to more modern applications
        written
        in Java or .NET by providing a Web service interface for the legacy system.
        Our
        tools also provide a Web-based display for legacy (3270) applications. These
        tools are noninvasive and allow the legacy application to remain
        untouched.
 
 
 23
 
 ***Enterprise
        IT Remediation***
 
 Our
        integrated set of *enterprise
        IT remediation* solutions enable companies to extend the life of their existing IT systems
        when
        facing ongoing regulatory changes and new business requirements. Our *remediation* solutions address a variety of corporate needs and include:
 
 *BluePhoenixTM
        FieldEnabler—* New
        business decisions or regulatory requirements often require companies to
        make
        changes that impact a wide range of system components. These include field
        adjustments that involve changes in the type, length, and structure of a
        database or program field, such as expanding a dealer code. *FieldEnabler* is a
        rule-based tool that enables a step-by-step, comprehensive process for making
        these kinds of modifications across an enterprise in a reliable and
        time-efficient manner.
 
 *BluePhoenixTM
        StandardsEnabler—* A
        highly
        automated solution for reliably facilitating system consolidation into a
        single
        set of naming standards. Since all resources being converted must be changed
        in
        parallel, the large task of manually standardizing the naming of system
        components is not practical. Our tool provides an automated solution addressing
        this problem.
 
 *BluePhoenixTM
        COBOL/LE-Enabler—* A
        highly
        automated solution that facilitates the migration of COBOL code from non-LE
        compliant environments to LE compliant environments.
 
 *BluePhoenixTM
        EuroEnabler—* A
        highly
        automated solution that enables the transformation of applications to be
        euro
        compliant. *EuroEnabler* fully
        preserves system and data integrity and helps to maintain existing levels
        of
        system application development and maintenance throughout the
        process.
 
 ***Enterprise
        IT Redevelopment***
 
 Enterprise
        IT environments are complex, and can prevent companies from quickly and easily
        adapting to new business needs and requirements. The more companies can organize
        and understand their applications, the faster they can adapt to inevitable
        changes. While organizations are mostly satisfied with the existing business
        functionality of their applications, they usually want to improve their business
        processes and leverage technologies such as Web-enabled and service-oriented
        architectures. Additionally, they are eager to find a way to decrease their
        maintenance costs, which typically consume 70%–80% of total IT
        spending.
 
 Our *enterprise
        IT redevelopment* suite
        enables companies to efficiently mine, reuse, and rewrite their existing
        applications, thus incrementally redeveloping their legacy systems, extending
        them into new technologies, and saving on development and programmer
        costs.
 
 *BluePhoenixTM
        AppBuilder* —Our
        primary redevelopment legacy environment has been used for managing,
        maintaining, and reusing the complicated applications needed by large
        businesses. It provides the infrastructure for enterprises worldwide, across
        several industries, with applications running millions of transactions daily
        on
        legacy systems. Enterprises using *AppBuilder* can
        build, deploy, and maintain large-scale custom-built business applications
        for
        years without being dependent on any particular technology until they cease
        using their legacy infrastructure. *AppBuilder* acts
        like a virtual application warehouse, keeping the underlying structure of
        the
        system in an organized framework such that developers can easily understand
        it.
        This allows companies to reuse critical business components, realizing a
        long-term return on investment for both new and existing
        applications.
 
 24
 
 
 *BluePhoenixTM*  *Redevelopment
        —* Based
        on
        AppBuilder and LogicMiner, *Redevelopment* transforms
        legacy COBOL programs into service oriented applications deployed on the
        latest
        platforms. The resulting application conforms to industry standards and is
        written in clean, maintainable source code. This conformance to standard
        architectures, such as full object-orientation and Web services, is a key
        differentiator in the *Redevelopment* approach
        when compared to more common migrations. Instead of using the common approach
        where each line of COBOL source code is translated to one or more statements
        in
        the target language (known as 1-1 approach), *Redevelopment* uses a
        model based approach. *Redevelopment* develops
        a platform independent model from platform specific models of legacy COBOL
        applications identified by BluePhoenix LogicMiner. This platform independent
        model may then be extended to meet new business requirements. Finally the
        application is generated to J2EE, .NET, or COBOL.
 
 *Visual
        MainWin® for the Unix and Linux platforms (formerly MainWin)—* Visual
        MainWin® for the Unix and Linux platforms is an application-porting platform
        that enables independent software vendors to develop applications in Visual
        C++
        and deploy them natively on Unix and Linux without the investment that is
        usually associated with designing and developing a new source code base for
        Unix
        platforms.
 
 In
        1994,
        Mainsoft entered into a licensing agreement with Microsoft, pursuant to which
        Microsoft granted Mainsoft access to specified Microsoft source code, including
        new versions, service packs, and upgrade releases for Windows. Microsoft
        also
        granted Mainsoft distribution rights to the Windows object code licensed
        as a
        component in Visual MainWin for Unix. *Visual
        MainWin for Unix* is
        already a mature product and Mainsoft primarily focuses on supporting and
        maintaining its existing *Visual
        MainWin for Unix* customers. We believe that our growth engine is the Visual MainWin for J2EE
        product described below.
 
 *Visual
        MainWin® for the J2EE platform—* During
        2006, Mainsoft continued to invest in the research and development, sales
        and
        marketing of its new *Visual
        MainWin® for J2EE* product,
        including the introduction of a Portal Edition. Mainsoft and IBM have been
        collaborating to market Visual MainWin for J2EE to IBM customers using or
        considering using WebSphere Portal in a mixed .NET-Java
        environment.
 
 25
 
 ***Investments
        and Acquisitions***
 
 In
        order
        to enhance our solutions and services portfolio, we have been pursuing a
        strategy of adding new technologies to our suite of automated modernization
        tools. We implement this strategy via internal development of new software
        tools
        and through acquisitions and investments. Accordingly, we devote significant
        resources to the development and marketing of new software modernization
        tools,
        and invest in businesses that develop
        software tools that are complementary to our existing portfolio. The broad
        portfolio that we established, among others, through these acquisitions,
        contributes to our ability to penetrate new markets and to offer a complete
        set
        of solutions addressing the broad array of changing demands of our
        customers. We
        integrate the acquired businesses into our business and assimilate many of
        their
        functions, including, marketing, sales, finance and administration into our
        existing infrastructure.
 
 Following
        is a description of our investments and acquisitions, which form a part of
        our
        business as described above:
 
 ***CodeStream
        Software Ltd.*** In
        December 2006, we acquired from a company incorporated in the United Kingdom,
        CodeStream Software Ltd., certain business activities in the field of
        modernization of legacy databases, particularly IDMS and other mainframe
        platforms. Pursuant to the purchase agreement, we hired 18 persons previously
        employed by CodeStream and assumed all the obligations in respect of the
        purchased activities. In consideration thereof, we paid CodeStream **₤** 5.2
        million (approximately $10.2 million). In addition, we undertook to issue
        to
        CodeStream a convertible debenture in a principal amount of **₤** 2.9
        million (approximately $5.7 million), if (i) not later than December 14,
        2008,
        we receive purchase orders from a key customer of CodeStream, in an aggregate
        amount of not less than **₤** 2.2
        million (approximately $4.3 million) ;
        and
        (ii) such purchase orders are collectible under the purchase orders not later
        than December 14, 2009. The debenture shall be issued upon the fulfillment
        of
        the aforementioned conditions and shall be due two years after the date of
        issuance. The debenture shall bear interest at a rate of LIBOR plus 1.5%
        calculated on a quarterly basis. Interest shall be calculated on the principal
        amount of the debenture beginning on December 14, 2006.
 
 In
        addition, we undertook to issue to CodeStream a second convertible debenture
        in
        a principal amount of **₤** 500,000
        (approximately $982,000), if (i) not later than December 14, 2010, we receive
        additional purchase orders from the same key customer of CodeStream, in an
        aggregate amount of not less than **₤** 800,000
        (approximately $1.6 million); and (ii) such purchase orders are collectible
        not
        later than 36 months after the first debenture was issued. The debenture
        shall
        be due two years after the date of issuance and shall bear interest at a
        rate of
        LIBOR plus 1.5% calculated on a quarterly basis. Interest will accrue on
        the
        principal amount of the debenture beginning on the date of issuance of the
        first
        debenture.
  The
        debentures will be convertible into BluePhoenix’s ordinary shares at a
        conversion rate of $6.00 per ordinary share, subject to adjustment for stock
        dividends, stock splits, recapitalization and other similar events. At the
        request of the holders of the debentures, given six months in advance, we
        will
        repay the amount of the debentures prior to their respective due dates. At
        the
        request of the holders of a majority of the shares underlying each of the
        debentures, given within 10 business days after issuance of the debenture,
        we
        will file a registration statement under the Securities Act 1933, referred
        to as
        the Securities Act, for an offering of the shares underlying the debentures.
        In
        addition, if we otherwise propose to register our ordinary shares under the
        Securities Act, the holders of the debentures may request that we register
        their
        underlying shares as well, subject to certain limitations. In the event that
        the
        repayment date of a debenture occurs earlier than 6 months after the
        registration statement becomes effective, then, the repayment date of the
        debenture shall be postponed until a date which is 6 months after the effective
        date of the registration statement. In the event that holders of 50% or more
        of
        the principal amount of a debenture request repayment of the debenture prior
        to
        its due date, we shall be released from our undertakings with respect to
        the
        registration described above.
 
 26
 
 ***BluePhoenix
        Solutions Srl. (previously known as AlphaTech (2000)
        Srl.).*** In
        December 2002, we purchased from Intercomp, our affiliate, a 65% controlling
        interest in AlphaTech (2000) Srl. for aggregate consideration of $100,000.
        In
        February 2005, we entered into an agreement with the other shareholder of
        AlphaTech to purchase for $250,000 its entire holdings in AlphaTech, which
        as of
        such date was equal to 35% of AlphaTech’s outstanding share capital. In
        2005,
        AlphaTech changed its name to BluePhoenix Solutions Srl. BluePhoenix Solutions
        Srl., a company incorporated in Romania, serves as our offshore delivery
        center
        in Romania.
 
 ***CePost.*** In
        January 2004, we purchased the entire outstanding share capital of CePost
        Ltd.,
        an Israeli company that
        develops and markets software solutions for electronic document mining,
        management and presentment .
        Pursuant to the purchase agreement, we paid to the shareholders of CePost
        $172,500 and issued to them 31,496 BluePhoenix’s ordinary shares. In addition,
        we undertook to pay to the sellers royalties from CePost’s revenues in an amount
        of up to $1.5 million. At our option, we may pay the royalties in BluePhoenix’s
        ordinary shares. In accordance with the purchase agreement, we paid to the
        sellers in 2005 and 2006 advances in an aggregate amount of $45,000 on account
        of the royalties.
 
 ***Intercomp.*** In 1998,
        we invested in Intercomp Ltd., which has developed a set of automated analysis
        and reengineering tools for legacy COBOL applications. During 2002 and 2003,
        Intercomp focused its efforts on the development of software tools that comprise
        a part of BluePhoenix LogicMiner. For more information about LogicMiner,
        see
“Research and Development—Enterprise IT Understanding—BluePhoenix
        LogicMiner.”
 
 In
          2004,
          we exercised an option granted to us to purchase from Eran Tirer all of
          its
          holdings in Intercomp, constituting 18.5% of the outstanding share capital
          of
          Intercomp. In consideration, we issued to Mr. Tirer warrants to purchase
          BluePhoenix ordinary shares which expired without being exercised. As part
          of
          the transaction with Mr. Tirer, certain shareholders of Intercomp, holding
          2.1%
          of Intercomp’s outstanding share capital, transferred to us their holdings in
          Intercomp. In addition, the remaining shareholders of Intercomp comprised
          of
          several funds acting through their general partner, Infinity, converted
          certain
          outstanding loans owed to them by Intercomp into 7,236 shares of Intercomp
          at a
          price of $162.70 per share. Following these transactions, our holdings
          in
          Intercomp increased from 49% to approximately 62%. Since the end of the
          first
          quarter of 2004, we have consolidated the results of operations of
          Intercomp.
 
 Concurrently
        with the grant by Mr. Tirer of the option to purchase from him his holdings
        in
        Intercomp, Intercomp granted nonexclusive rights to a distributor partially
        owned by Mr. Tirer, to further develop and distribute Intercomp’s products.
 
 27
 
 In
        April
        2004, Infinity granted us a call option to purchase its entire holdings in
        Intercomp. The option expired without being exercised by us. As a result,
        Infinity exercised a put option granted to it, to cause us to purchase
        Infinity’s entire holdings in Intercomp. In consideration for Intercomp’s
        shares, we issued to Infinity 100,719 BluePhoenix ordinary shares. As previously
        agreed with Infinity, we filed a registration statement under the Securities
        Act
        with respect to the ordinary shares issued to Infinity. Subsequent to the
        exercise of the option by Infinity, we currently wholly own
        Intercomp.
 
 In
        the
        first quarter of 2006, FIMI, a creditor of Intercomp, has completed exercising
        a
        put option to sell to us convertible promissory notes issued by Intercomp,
        in an
        aggregate principal amount of $3.5 million. The put option was originally
        granted to FIMI in January 2001. As consideration thereof, we paid FIMI an
        aggregate amount of $4.48 million including interest accrued, which equals
        the
        book value of the promissory notes, and issued to FIMI warrants to purchase
        210,000 BluePhoenix’s ordinary shares at an exercise price of $4.00 per share.
        No gain or loss was recorded at the repayment date. In the first quarter
        of 2007
        FIMI exercised all its warrants.
 
 ***I-Ter/Informatica
        & Territorio S.p.A.*** In
        the
        second quarter of 2005, we entered into an agreement to purchase the entire
        outstanding share capital of I-Ter. I-Ter is a developer and marketer of
        software solutions for migration from DL1 to DB2, and from IMS/DC to CICS,
        porting of applications from mainframe and Unix Sun Solaris. Pursuant to
        the
        purchase agreement, we paid to the selling shareholders of I-Ter $1.4 million.
        Under the terms of the transaction, we agreed to pay the selling shareholders
        an
        additional consideration of up to $720,000 calculated based on I-Ter’s
        cumulative earnings before interest and taxes, referred to as EBIT. As agreed,
        if the EBIT in any calendar year during the three-year period commencing
        on
        January 1, 2005, is equal to or greater than $6,000, we will pay the selling
        shareholders an additional $240,000 with respect to each such year. In 2006,
        we
        paid to the selling shareholders $240,000 since I-Ter met the criteria in
        2005.
        In 2006, the EBIT exceeded the minimal level, and therefore we are required
        to
        pay the selling shareholders $240,000. In addition, we agreed to pay to the
        selling shareholders, at such date that is 15 business days following the
        date
        on which the EBIT report for the year ended on December 31, 2007 is final,
        additional consideration equal to seven times the yearly average EBIT in
        the
        three-year period commencing on January 1, 2005, less the amounts already
        paid
        to the selling shareholders for the purchased shares. In addition, in the
        event
        that the yearly average EBIT in the three-year period commencing on January
        1,
        2005 is greater than $600,000, we shall pay the selling shareholders an amount
        equal to nine times of the difference between the yearly average EBIT in
        the
        three-year period commencing on January 1, 2005 and $600,000.
 
 ***MultiConn.*** In
        1999,
        we acquired 51% of the outstanding share capital of M.S.I. MultiConn Solutions
        International (1995) Ltd., referred to as M.S.I. MultiConn, and in 2000,
        we
        increased our shareholdings in M.S.I. MultiConn to 60%. Effective as of January
        2004, the other shareholders of M.S.I. MultiConn transferred their entire
        holdings in M.S.I. MultiConn to us. Following this transaction, we assumed
        control over the daily management of M.S.I. MultiConn. We currently wholly
        own
        M.S.I. MultiConn and finance its activities.
 
 28
 
 In
        2000,
        we established together with the other shareholders of M.S.I. MultiConn,
        a
        company named MultiConn Technologies Ltd. and initially owned 19% of its
        share
        capital. MultiConn Technologies develops and markets BluePhoenixTM SOA - Ready
        Enablement. In 2002, we increased our holdings in MultiConn Technologies
        to 60%.
        Following a transaction entered into between us and the other shareholders
        of
        MultiConn Technologies in 2004, the other shareholders of MultiConn Technologies
        increased their holdings in MultiConn Technologies to 58.2% in the aggregate,
        through the issuance of shares by MultiConn Technologies. As a result, we
        currently hold approximately 40% of the outstanding share capital of MultiConn
        Technologies. We have an option to increase our holdings in MultiConn
        Technologies to 60% of its outstanding share capital for an exercise price
        of
        $50,000. As of March 22, 2007, we lent to MultiConn Technologies an aggregate
        amount of $2.5 million. In 2004, we included in our equity in affiliated
        companies 100% of the losses of MultiConn Technologies. As of December 31,
        2004,
        we consolidate MultiConn Technologies’ balance sheet with ours. For more
        information about BluePhoenixTM SOA - Ready Enablement, see “Enterprise IT
        Migration—BluePhoenixTM SOA - Ready Enablement.”
 
 ***Outlook.*** Effective
        as of January 2004, we acquired from an Israeli company, Outlook Systems
        Ltd.,
        through our new wholly owned subsidiary, Outlook & BluePhoenix Ltd., Outlook
        Systems’ entire business activities in Israel in the field of software
        development services. Pursuant to the purchase agreement, we hired 31 employees
        previously employed by Outlook Systems and assumed all the obligations in
        respect of the purchased activity. Under the purchase agreement, as amended
        in
        2006, we paid to Outlook Systems an aggregate amount of approximately $1.3
        million. In accordance with the amendment to the purchase agreement, a guarantee
        given by us to secure bank loans of Outlook Systems, was cancelled. In addition,
        Outlook Systems received 138,591 of BluePhoenix ordinary shares. As part
        of the
        amendment, we undertook to pay Outlook Systems a consideration to be calculated
        based on Outlook & BluePhoenix Ltd.’s annual earnings before interest and
        taxes, referred to as EBIT, during the three-year period commencing on July
        1,
        2005, as follows:
 
 ·
              For
                  an amount of up to $300,000 of the annual EBIT in each year within
                  the
                  three-year EBIT period, we will pay Outlook Systems a consideration
                  equal
                  to 10% of the EBIT;
 ·
              For
                  an amount of annual EBIT in a fiscal year within the three-year
                  EBIT
                  period in excess of $300,000, we will pay Outlook Systems additional
                  consideration equal to 15% of the excessive
                  amount.
 
 Based
        on
        the EBIT during the eighteen months commencing on July 1, 2005, the accrued
        contingent consideration is $35,000.
 
 ***Zulu
        Software Inc.*** In
        February 2005, we entered into an agreement to purchase up to 20% of the
        outstanding share capital of Zulu Software, Inc., or Zulu, on a fully diluted
        basis. Under the purchase agreement, the purchase price was divided into
        four
        installments, each to be paid subject to fulfillment of a certain milestone.
        We
        paid the first installment of $350,000 in February 2005 against the issuance
        to
        us of 8% of Zulu’s outstanding share capital. We have not made additional
        payments because the agreed upon milestones have not been met. In January
        2006,
        we purchased from the other shareholders of Zulu additional shares increasing
        our holdings to 72% of Zulu’s outstanding share capital. The aggregate
        consideration we paid for this additional purchase was $2.4 million. Zulu
        is a
        developer and marketer of software solutions for migration from ADABAS/Natural
        to Java. For more information about Zulu’s software solutions, see “Enterprise
        IT Migration—BluePhoenix *TM* LanguageMigrator.”
 
 29
 
 ***Cicero
        Inc.*** *(formerly
        Level 8 Systems Inc.)* .
        As of
        March 22, 2007, we hold several capital instruments, including warrants and
        rights to receive warrants, exercisable into shares of Cicero Inc. If we
        exercise these capital instruments in full, we will hold approximately 545,000
        ordinary shares of Cicero. As of March 22, 2007, we provided Bank Ha’Poalim with
        a guarantee securing Cicero’s bank loans, in an amount of approximately $2
        million. The guarantee is extended from time to time and it is currently
        in
        effect until November 2007. In consideration for the extension of the guarantee,
        Cicero issues to us ordinary shares. In the event that the guarantee is
        exercised, the bank is obligated to grant to us a loan for a three-year period
        in an amount of up to the amount of the guarantee.
 
 In
        September 2004, we extended a loan to Cicero of approximately $97,000 under
        a
        secured promissory note. The note bears interest at an annual rate of 10%.
        In
        consideration, we are entitled to receive warrants to purchase 19,865 ordinary
        shares of Cicero at an exercise price of $1 per share.
 
 ***Customers***
 
 We
        provide our modernization solutions directly or through our strategic partners,
        such as IBM, EDS, NCS, Matrix, and TACT. Additionally, from time to time,
        other
        IT services companies license our technologies for use in modernization projects
        in various markets. Our partners are usually system integrators who assist
        us in
        increasing our penetration and exposure in the market. We provide solutions
        to
        our partners’ customers in collaboration with the system integrator’s team. In
        most cases, the partners provide related services to the customers. Our
        arrangements with our partners vary. We may enter into distribution agreements
        with our partners under which we grant license rights or to the partners’
customers, provide related services, or a combination of both. Alternatively,
        we
        may enter into subcontractor relationships with our strategic
        partners.
 
 A
        substantial portion of our agreements are based on fixed price contracts.
        These
        projects may bear some risks and uncertainties as we price these contracts
        based
        on estimates of future costs, duration of the project and the impact of
        potential changes in the scope of the work. We also enter into other types
        of
        contracts, including annual maintenance contracts, license agreements and
        arrangements on a time and material basis. To date, shifts in revenues generated
        from different types of agreements have not materially affected our results
        of
        operations.
 
 Our
        customers include, among others:
 **Financial
                      Services**
                  
                  **Insurance**
                  
                  **Other
                      Industries**·
                  Citibank
                  
                  ·
                  American
                      Family Life Assurance company of Columbus
                  
                  ·
                  Ansys
                      Inc. Canonburg·
                  Credit
                      Suisse
                  
                  ·
                  DesJardins
                      General Insurance Group Inc.
                  
                  ·
                  Altera
                      Corporation·
                  Fidelity
                      International Resource Management
                  
                  ·
                  Employees
                      retirement system
                  
                  ·
                  Business
                      Objects Corp.
 
 30
 **Financial
                      Services**
                  
                  **Insurance**
                  
                  **Other
                      Industries**·
                  Laiki
                      Group
                  
                  ·
                  Europe
                      Assistance
                  
                  ·
                  Commonwealth
                      of Australia represented by the Department of Immigration and
                      Multicultural and Indigenous Affairs·
                  Rabobank
                      Netherland BV
                  
                  ·
                  Friends
                      Provident Management Services Ltd.
                  
                  ·
                  Daimler
                      Chrysler AG·
                  Rural
                      Servicios Informaticos (Spain)
                  
                  ·
                  Legal
                      and general Resources
                  
                  ·
                  Erhervs-og
                      Selskabsstyrelsen·
                  SDC
                      Udvikling (Denmark)
                  
                  ·
                  Scottish
                      Equitable Plc.
                  
                  ·
                  ESRI
                      – Environmental Research Institute, Inc·
                  Woolwich
                      PLC
                  
                  ·
                  The
                      New York City
                  
                  ·
                  IBM
                      de Mexico Comercializaion y- servicios S.A·
                  IBM
                      (Rational Software)·
                  Lawson
                      Products·
                  Mentor
                      Graphics Corporation·
                  Ministry
                      of Defense (Israel)·
                  Siebel
                      Systems, Inc·
                  Toyota
                      Motor Sales, USA, Inc.·
                  TEMENOS
                      Group
  Each
        of
        the customers mentioned above contributed at least $600,000 to our annual
        revenues for a project performed within the previous two fiscal
        years.
 
 SDC
        Udvikling A/S, referred to as SDC Udvikling, an affiliated company of SDC,
        accounted for 11% and 17% of our revenues in 2006 and 2005,
        respectively.
 
 Temenos
        group accounted for 15% of our revenues in 2006.
 
 The
        following table summarizes the revenues from our tools and services by
        geographic regions for the periods indicated
 
 **Year
                  ended December 31,****2006**
              
              **2005**
              
              **2004****(in
                  thousands)**United
                  States
              
              $
              15,048
              
              $
              17,423
              
              $
              20,438Europe
                  (other than Denmark)
              
              
              28,449
              
              
              18,643
              
              
              15,860Denmark
              
              
              10,304
              
              
              12,334
              
              
              10,122Israel
              
              
              10,156
              
              
              7,991
              
              
              8,353Other
              
              
              4,047
              
              
              2,556
              
              
              2,413Total
              
              $
              68,004
              
              $
              58,947
              
              $
              57,186
 
 ***Research
        and Development***
 
 In
        order
        to maintain our position as a market leader in the IT modernization market,
        we
        are focusing our development efforts on further enhancements to current
        solutions, as well as addressing newly emerging aspects of the modernization
        market. We are planning additional software development activities to extend
        our
        modernization solutions by leveraging our technological skills to create
        added
        value for our customers and to generate additional business
        opportunities.
 
 31
 
 The
        next
        generation of our solutions will be extended to address the entire modernization
        process from legacy systems to modern platforms. We have started to develop
        our
        next generation of products and tools, which will allow the fluent
        transformation of legacy code to state-of-the-art platforms, such as J2EE
        and
        .NET. The new generation of solutions is composed of products and tools in
        several EIM categories.
 
 *Enterprise
        IT Understanding*
 
 *BluePhoenixTM
        IT Discovery—* By
        further refining our existing understanding technology and combining it with
        the
        additional technology licensed from Merrill Lynch, IT Discovery will
        provide the basis for legacy understanding needed by the rest of our
        modernization solutions.
 
 *Enterprise
        IT Automated Migration*
 
 *Fourth
        Generation Language Migration* —In
        the
        area of automated migration, we continue to build on our 4GL migration
        solutions. Our assets in the migration area cover COOL:Gen, Mantis, ADSO/IDMS,
        Natural, CSP, and PowerBuilder transformations. We continue to extend the
        support target platform of these transformations to include J2EE and .NET
        platforms.
  *Enterprise
        IT SOA Ready Solution* —A
        comprehensive solution that provides Web services or clients for a legacy
        application. Our unique suite of tools enables a legacy application to be
        exposed to more modern applications written in Java or .NET by providing
        a web
        service interface for the legacy system. In addition, our tools are able
        to
        provide a web based appearance/ connectivity/ interface legacy applications.
        Both solutions are not intrusive and allow the legacy application to remain
        untouched.
 
 *BluePhoenixTM
        LogicMiner—* A
        comprehensive solution for recovery that mines COBOL and extracts business
        rules
        from the legacy code, thus providing IT departments with the ability to begin
        a
        modernization process based on techniques that preserve the functionality
        of a
        legacy code. This tool retains past investments in software assets by producing
        reusable code objects or descriptive data that can later be used for improving
        the quality of the legacy code, rewriting the legacy application, or building
        a
        full modernization plan. *LogicMiner* increases a system’s manageability, while eliminating rules that no longer apply
        to current business procedures.
  *BluePhoenixTM
        Refactoring Repository* —A
        repository that supports the storage and management of the abstract models
        and
        code of applications that make use of multiple development architectures
        such as
        legacy information engineering and more modern object oriented and service
        oriented architectures.
 
 32


*BluePhoenixTM*  *Redevelopment* —Once
      legacy models and code are refactored, *Redevelopment* will
      provide the ability to generate from the abstract platform independent model
      stored in the *Refactoring
      Repository* to
      platform specific models such as J2EE and .NET. To address this, we are
      extending robust generation technologies to generate platform specifics for
      object orientation and SOA. This model driven modernization environment can
      be
      used to gradually migrate applications rather than requiring an “all at once”
approach. In order to address refactoring, which involves changing from one
      application model to another, we are adding the necessary tools to assist in
      the
      process of taking the information from legacy applications’ architectures via *LogicMiner* to more
      modern architectures such as object and SOA.





*Mainsoft’s
      Visual MainWin® for the J2EE platform* —Mainsoft’s
      Visual MainWin® for the J2EE platform is a cross-platform development solution
      that bridges the .NET/J2EE divide, enabling Visual Basic .NET and C# developers
      to develop J2EE Web applications and Web services using the Visual Studio .NET
      development environment. Version 1.7 of Visual MainWin® for the J2EE platform,
      introduced in December 2005, supports the IBM partnership, including validation
      on all IBM eServer product line and support for IBM WebSphere Express and
      WebSphere Application Server 6.0. In 2006, Mainsoft identified the enterprise
      portal market opportunity and launched a portal edition of the product
      supporting IBM WebSphere Portal. This product is based on the Mono project,
      an
      open source .NET implementation, led by Novell and it is not dependant upon
      Microsoft source code.




Mainsoft
      continues to market Visual MainWin for Unix. Its current release supports Visual
      Studio 2005 and additional UNIX and Linux platforms.




*Costs
      and Grants*





As
      of
      December 31, 2006, we employed 150 employees in our software development
      departments. Our net development expenditures were $9.4 million in 2006, $8.0
      million in 2005 and $8.1 million in 2004. Certain of our new product development
      projects have been awarded research grants, of which some that are repayable
      as
      royalties.





*Chief
      Scientist Grants*





*Visual
      MainWin® for J2EE Platform* —Through
      December 31, 2006, our subsidiary, Mainsoft, accrued an aggregate of
      approximately $1.8 million in grants from the Office of the Chief Scientist,
      or
      the OCS, for the development of Visual MainWin® for J2EE. Royalties of 3% are
      payable to the OCS on sales of Visual MainWin® for J2EE, up to 100% of the
      dollar-linked grant received in respect of the funded product. To date, Mainsoft
      has paid the royalties to the OCS as required. Mainsoft has submitted to the
      OCS
      an application for obtaining research and development grants for 2007, which
      is
      pending approval.





*PowerText* —As
      of
      January 1, 2004, we received through our wholly owned subsidiary, an aggregate
      of approximately $200,000 in grants from the OCS for the development of
      PowerText. PowerText is a software solution for automated electronic document
      mining, management and presentment. Royalties of 3% are payable to the OCS
      on
      all sales of PowerText up to 100% of the dollar-linked grant received. To date,
      CePost has paid to the OCS the royalties as required.





33




*BluePhoenixTM
      SOA - Ready Enablement* —Through
      December 31, 2004, our subsidiary, MultiConn Technologies, accrued an aggregate
      of approximately $580,000 in grants from the OCS, for the development of
      BluePhoenixTM SOA - Ready Enablement. Royalties of 3% are payable to the OCS on
      sales of BluePhoenixTM SOA - Ready Enablement up to 100% of the dollar-linked
      grant received in respect of the funded product.





The
      balance of the contingent liability relating to the royalties payable by our
      subsidiaries to the OCS, at December 31, 2006, amounted to approximately $2.5
      million.





*Other
      Grants*





In
      the
      first quarter of 2004, the Singapore-Israel Industrial Research and Development
      Foundation agreed to provide one of our wholly owned subsidiaries together
      with
      a company incorporated in Singapore, financing for the development of a Java
      report generator based on legacy text file input. Accordingly, the foundation
      agreed to award our subsidiary up to $100,000 payable according to an agreed
      upon schedule. As of March 22, 2007, we received $45,000 of the grant. The
      grant
      is required to be repaid in installments based on sales of the funded product
      up
      to the amount of the grant.





Our
        subsidiary, I-Ter, is entitled to funds to develop Easy4Plan product, from
        the
        Ministry of Production in Italy. Easy4Plan is a workflow management tool
        designed for ISO9000 companies. Approximately 30% of the funds are a grant,
        and
        the balance is an 8-year loan to be repaid by I-Ter. The loan bears a minimal
        annual interest. The development term ended in September 2006. Pending the
        final
        approval of the Ministry of Production, we anticipate that during 2007, I-Ter
        will receive a total aggregate amount of approximately
        $650,000.




***Intellectual
      Property***




We
      rely
      on a combination of trade secret, copyright, and trademark laws and
      nondisclosure agreements, to protect our proprietary know-how. Our proprietary
      technology incorporates processes, methods, algorithms, and software that we
      believe are not easily copied. Despite these precautions, it may be possible
      for
      unauthorized third parties to copy aspects of our products or to obtain and
      use
      information that we regard as proprietary. However, we believe that with regard
      to most of our solutions, because of the rapid pace of technological change
      in
      the industry, patent and copyright protection are less significant to our
      competitive position than factors such as the knowledge, ability, and experience
      of our personnel, new product development, and ongoing product maintenance
      and
      support.




**Competition**




The
      modernization market in which we operate is highly competitive. The principal
      competitive factors affecting the market for our modernization solutions
      include:





·  product
      functionality, performance, and reliability;


·  technical
      range of the offered solutions;


·  integration
      between the offered solutions;




34


·  availability
      of experienced personnel and its expertise;


·  prices;


·  ability
      to respond in a timely manner to changing customer needs;


·  quality
      of support and vertical market expertise.





Competition
      in the enterprise IT modernization field is, to a large extent, based upon
      the
      functionality of the available tools and personnel expertise. Vendors in this
      market address the modernization of legacy systems in different ways, and
      therefore do not always compete directly with the others. Many small vendors
      address only a small part of the market, providing IT specific solutions. Only
      a
      few vendors offer more comprehensive and integrated tools and solutions that
      can
      respond to the most challenging modernization issues that companies are facing.
      Some large vendors, such as Oracle, HP and Intel have joined forces to lead
      the
      market in an organized mainframe modernization initiative, the Application
      Modernization Initiative (AMI). These three vendors also intend to create a
      selected consortium of vendors in order to broaden the depth and breadth of
      their migration offering.





Our
      principal competitors consist of system integrators, offshore outsourcers,
      and
      tool vendors, including leading
      software developers ,
      who
      enable the replacement or modernization of legacy systems. Major system
      integrators in the market include IBM, Accenture, Capgemini, and EDS. IBM has
      established legacy modernization as a strategic aspect of its long-term
      application development strategy. Major system integrators have a specific
      and
      dominant advantage in the underlying application development infrastructure
      associated with many legacy environments (predominantly IBM mainframes) and
      a
      large service delivery capability. In some cases, we cooperate with some of
      these system integrators in providing specific solutions or
      portions of comprehensive projects. Major offshore outsourcers in the market
      include TCS (Tata Consulting Services), WIPRO, Patni, and Infosys. Both systems
      integrators and
      offshore outsourcers have vertical market groups offering consulting and
      professional services.





We
      also
      face competition from niche tools and solutions companies operating in each
      of
      the four principal areas of the enterprise IT
      modernization  market :





·  Enterprise
      IT Understanding;


·  Enterprise
      IT Migration;


·  Enterprise
      IT Remediation; and


·  Enterprise
      IT Redevelopment.





For
      example, Cast Application Intelligence Platform reads application source code
      to
      analyze the fine-grained relationships among software artifacts - objects,
      functions, stored procedures, database tables and columns, scripts and
      others.  MetaWare
      provides services and products such as re-hosting, database and programming
      language conversions. Most Software Technologies addresses the ADABAS/Natural
      arena, and other competitors focus on collecting sufficient information about
      application portfolios to improve business processes. Other solution developers
      provide distributed repository solutions and architecture modernization
      services.




35




**C.**  **Organizational
      Structure**




We
      are
      part of the Formula group, a global IT solutions and services group
      headquartered in Israel. The Formula group is principally engaged in providing
      software consulting services, developing proprietary software products, and
      providing computer-based business solutions. The Formula group delivers its
      solutions in over 50 countries worldwide to clients with complex IT services
      needs, including a number of “ Fortune
      1000 ” companies. We are a subsidiary of Formula Systems (1985) Ltd., which holds
      52.3%
      of our ordinary shares.




Following
      is a list of our significant subsidiaries, their country of incorporation,
      and
      proportion of our ownership interest in them, as of March 22, 2007:





**Name of Subsidiary**
            
            **Country of Incorporation**
              **Incorporation**
            
            **Proportion of OwnershipInterest**BluePhoenix
                Solutions B.V.
            
            The
                Netherlands
            
            100%Liraz
                Systems Ltd.
            
            Israel
            
            100%Mainsoft
                Corporation
            
            United
                States
            
            58%




**D.**  **Property,
      Plants and Equipment**




We,
      together with our subsidiaries and affiliates, currently occupy approximately
      9,800 square meters of office space. The aggregate annual rent we paid for
      these
      facilities in 2006 was $1.9 million. The following table presents certain
      information about our facilities and the terms of lease of these
      facilities.




**Country and State**
              
              **City**
              
              **Sq.Meters**
              
              **Expiration**
              
              **Annualanticipatedrental
                  fees in2007****(*)****in thousands $**Israel
              
              
              Herzlia
              
              
              2,170
              
              
              December 2008
              
              
              375Israel
              
              
              Holon
              
              
              253
              
              
              February 2007
              
              
              30Israel
              
              
              Lod
              
              
              1,076
              
              
              June 2007
              
              
              146USA,
                  North Carolina
              
              
              Cary
              
              
              860
              
              
              April 2009
              
              
              200USA,
                  California
              
              
              San
                  Jose
              
              
              350
              
              
              November 2007
              
              
              80USA,
                  California
              
              
              Santa
                  Clara
              
              
              160
              
              
              October 2008
              
              
              36USA,
                  Indiana
              
              
              South
                  Bend
              
              
              400
              
              
              February 2008
              
              
              84Denmark
              
              
              Ballerup
              
              
              1,759
              
              
              November 2008
              
              
              365Germany
              
              
              Frankfurt
              
              
              265
              
              
              November 2007
              
              
              48Romania
              
              
              Bucharest
              
              
              900
              
              
              November 2007
              
              
              162




36




**Country and State**
                
                **City**
                
                **Sq.Meters**
                
                **Expiration**
                
                **Annualanticipatedrental
                    fees in2007****(*)****in thousands $**United
                    Kingdom
                
                
                Uxbridge
                
                
                40
                
                
                August 2007
                
                
                54United
                    Kingdom
                
                
                Milton
                    Keynes
                
                
                80
                
                
                June 2007
                
                
                112Cyprus
                
                
                Nicosia
                
                
                800
                
                
                June 2009
                
                
                132Italy
                
                
                Milan
                
                
                150
                
                
                October 2010
                
                
                30Italy
                
                
                Riccione
                
                
                330
                
                
                December 2010
                
                
                42Italy
                
                
                Milano
                
                
                110
                
                
                April 2012
                
                
                18Italy
                
                
                Roma
                
                
                124
                
                
                September 2011
                
                
                34**Total**
                
                
                
                
                
                **9,827**
                
                
                
                
                
                **1,948**


(*) Includes
      related fess such as management fees, maintenance, parking etc.





If,
      in
      the future, we determine that we need additional space to accommodate our
      growth, we believe that we will be able to obtain this additional space without
      difficulty and at commercially reasonable prices. We do not own any real
      property.




**ITEM
      4A. UNRESOLVED STAFF COMMENTS**




Not
      applicable.




**ITEM
      5. OPERATING AND FINANCIAL REVIEW AND PROSPECTS**




**Background**





We
      develop and market unique value driven enterprise IT modernization solutions
      that enable companies to automate the process of modernizing and upgrading
      their
      mainframe and distributed IT infrastructure and to effectively compete in
      today’s environment. The combination of our comprehensive set of products and
      tools with our expert services methodology provides an efficient and
      cost-effective process for extending the return on investment of existing
      enterprise IT assets. Our solutions, which include technology for *Understanding,
      Migration, Remediation* ,
      and *Redevelopment* ,
      allow
      companies to fully leverage their current systems and applications, speed up
      and
      reduce the cost of the renewal process, and effectively update their systems
      in
      order to adapt to new business demands.





37




Our
      quarterly and annual results of operations have fluctuated significantly in
      the
      past and we expect them to continue to fluctuate significantly in the future,
      as
      a result of numerous factors, including the changes in the suite of
      modernization tools we have been offering to our customers, the impact of
      acquisitions and dispositions of companies, and the difficulties we have
      encountered in introducing our tools to the markets. Therefore, we believe
      that
      period-to-period comparisons of our financial results are not necessarily
      meaningful and you should not rely on them as an indication for future
      performance.





The
      following discussion of our critical accounting policies and our financial
      condition and operating results should be read in conjunction with our
      consolidated financial statements and related notes, prepared in accordance
      with
      U.S. GAAP for the years ended December 31, 2006, 2005 and 2004, and with any
      other selected financial data included elsewhere in this report.




**Overview**




***General***




In
      recent
      years, we have been affected by the global economic changes, in particular
      trends in capital spending in the information technology sector. During 2001
      through 2003, the overall business slowdown in the North American and European
      markets influenced the purchasing patterns of leading software developers who
      delayed their planned orders and caused developers to reduce the amount of
      their
      planned commitment. These changes in purchasing patterns in the IT industry
      directly affected our operating results. Our revenues decreased from $49.2
      million in 2000 to $38.4 million in 2001 and to $36.7 million in 2002. Since
      2003, as a result of a recovery of the market, and the impact of strategic
      acquisitions we completed, this trend changed, and our revenues increased from
      $57.2 million in 2004 to $58.9 million in 2005 and $68 million in 2006. As
      part
      of this change, our average backlog increased from approximately $25 million
      at
      the end of 2004 to $50 million at the end of 2005 and $80 million at the end
      of
      2006. This increase improves management’s ability to engage in near-term
      planning. We typically fill current backlog within one year.





In
      providing our solutions, we work closely with our customers or system
      integrators, and can therefore be impacted by holiday seasons of customers
      and
      system integrators. As a result, we may sometimes experience a decline in our
      third quarter revenues due to the summer holiday season in Europe and
      Israel.





In
      order
      to enhance our solutions and services portfolio, we have been pursuing a
      strategy of adding new technologies to our suite of automated modernization
      tools. We implement this strategy via internal development of new software
      tools
      and through acquisitions and investments. Accordingly, we devote significant
      resources to the development and marketing of new software modernization tools.
      In addition, we invest in businesses that develop
      software tools that are complementary to our existing portfolio and have a
      skilled and specialized workforce.




38




***Challenges
      and Opportunities***




Our
      principal objective is to enhance our revenues by leveraging the marketing
      resources and skilled specialized workforce to market the suite of tools and
      solutions that we offer. In addition, we have identified a market demand for
      complementary application development services. Our SOA-ready solution is
      provided as a post-migration service, allowing customers to extend their
      development environment by providing access to mainframe systems through Web
      services protocols, making legacy systems appear as modern systems. Therefore,
      we anticipate an increase in revenues generated from our customers, by offering
      them SOA-ready solutions and other “post-migration” services.





The
      principal challenge we face is to accomplish our growth objectives while also
      enhancing profitability. In order to expand our revenue base, we will continue
      to invest in our sales and marketing operations and penetrate additional markets
      such as Far East Asia. In preparation for the expansion of our business we
      are
      anticipating the need to expand our off-shore delivery centers. As part of
      this
      process we will evaluate the viability of moving or consolidating support and
      delivery centers to continue to increase efficiencies and margins.





Since
      our
      margins are dependent on the degree of automation of our tools, we plan to
      continue devoting substantial resources to research and development both
      internally and through acquisitions. There is no assurance that these
      investments will lead to revenue growth. If they do not lead to growth as
      anticipated, our profitability will be adversely affected.





Since
      2003, we have been enhancing our offshore delivery centers in Romania and
      Cyprus, where our operational costs are lower. These offshore centers allow
      us
      to reduce the prices we charge our customers for our solutions and
      simultaneously improve our operating profit. Recently, professional work in
      these countries became more expensive and professional fees may continue to
      increase in the future. As a result, we may consider establishing offshore
      facilities in other countries. The establishment of such additional facilities,
      may result in significant capital expenses which may affect our cash position.
      As the degree of automation of our tools increases, the need for expert services
      decreases, and as a result, our direct expenses decrease. In addition, the
      improved tools enable us to implement our distributed project methodology,
      and
      simultaneously use our delivery centers that perform the actual modernization
      project with our tools. ****




***Consolidation
      of the Results of Operations of Our Subsidiaries***





Following
      is information regarding the consolidation of the results of operations of
      certain of our subsidiaries, for the periods indicated. We began to consolidate
      the results of operations of each of these subsidiaries when we acquired control
      in them.





**Name
                of Subsidiary**
            
            **Beginning
                Consolidation**CePost
                Ltd.
            
            First
                quarter of 2004Outlook
                & BluePhoenix Ltd.
            
            First
                quarter of 2004Intercomp
                Ltd.
            
            Second
                quarter of 2004MultiConn
                Technologies Ltd.
            
            First
                quarter of 2005I-Ter/Informatica
                & Territorio S.p.A.
            
            Second
                quarter of 2005Zulu
                Software Inc.
            
            First
                quarter of 2006




39




***Critical
      Accounting Policies***





We
      prepare the consolidated financial statements of BluePhoenix in conformity
      with
      U.S. GAAP. Accordingly, we are required to make certain estimates, judgments
      and
      assumptions that we believe are reasonable based upon the information available.
      These estimates and assumptions affect the reported amounts of assets and
      liabilities at the date of the financial statements and the reported amounts
      of
      revenues and expenses during the periods presented. The significant accounting
      policies that we believe are the most critical to aid in fully understanding
      and
      evaluating our reported financial results include the following:





· *Revenue
      recognition.* Our
      revenue recognition policy is significant because our revenue is a key component
      of our results of operations. We follow specific and detailed guidelines in
      measuring revenue; however, certain judgments affect the application of our
      revenue policy. Revenue results are difficult to predict and any shortfall
      in
      revenue or delay in recognizing revenue could cause our operating results to
      vary significantly from quarter to quarter and could result in future operating
      losses. Should changes in conditions cause management to determine that these
      guidelines are not met for certain future transactions, revenue recognized
      for
      any reporting period could be adversely affected.





We
      recognize revenues from direct software license agreements in accordance with
      statement of position (SOP) 97-2 “Software Revenue Recognition” (as amended by
      SOP 98-4 and SOP 98-9) upon delivery of the software when collection is
      probable, the license fee is otherwise fixed or determinable, and persuasive
      evidence of an arrangement exists.





When
      a
      project involves significant production, modification or customization of
      software, and with respect to fixed fee contracts, revenue is generally
      recognized according to the percentage of completion method in accordance with
      the provisions of SOP 81-1 “Accounting for performance of Construction-Type
      Contracts.” Under this method, estimated revenue is generally accrued based on
      costs incurred to date as a percentage of total updated estimated costs. If
      we
      do not accurately estimate the resources required or the scope of work to be
      performed, or do not manage our projects properly within the planned periods
      of
      time or satisfy our obligations under the contracts, then future margins may
      be
      significantly and negatively affected or losses on existing contracts may need
      to be recognized. Any such resulting reductions in margins or contract losses
      could be material to our results of operations. We recognize contract losses,
      if
      any, in the period in which they first become evident.





Under
      some of our agreements, the customer may have the right to receive unspecified
      upgrades on a when-and-if available basis. These upgrades are considered
      post-contract customer support, referred to as PCS, and the fair value allocated
      to this right, is recognized ratably over the term of the PCS.





40




There
      are
      no rights of return, price protection or similar contingencies in our contracts.
      Accordingly, we do not establish a provision due to the lack of warranties
      claims in the past. Some of our contracts include client acceptance clauses.
      In
      determining whether revenue can be recognized, when an acceptance clause exists,
      we consider our history with similar arrangements, the customer’s involvement in
      the progress, the existence of other service providers and the payments
      terms.





· *Capitalized
        software research and development costs.* Development
        costs of software that is intended for sale that were incurred after the
        establishment of technological feasibility of the relevant product, are
        capitalized. Technological feasibility is determined when detailed program
        design is completed and verified in accordance with the provisions of the
        FASB
        Statement of Financial Accounting Standards No. 86 (SFAS 86). Software
        development costs incurred before technological feasibility is established
        are
        charged to the statement of operations as incurred net of participation of
        the
        office of the Chief Scientist (OCS). Our policy on capitalized software costs
        determines the timing of our recognition of certain development costs. In
        addition, this policy determines whether the cost is classified as development
        expense or capitalized costs. Management is required to use professional
        judgment in determining whether development costs meet the criteria for
        immediate expense or capitalization. Amortization of capitalized software
        development costs begins when the product is available for general release
        to
        customers. Annual amortization is computed by the straight-line method, over
        the
        remaining useful life of the product, currently over a period of 5 years,
        or
        based on the ratio of current gross revenues to current and anticipated future
        gross revenues, whichever is higher. Our failure to accurately predict the
        useful life of capitalized software could cause a one-time amortization,
        which
        could adversely affect our operating results.





· *Impairment
      of goodwill and intangible assets.* Our
      business acquisitions resulted in goodwill and other intangible assets. We
      periodically evaluate our goodwill, intangible assets, and investments in
      affiliates for potential impairment indicators. Our judgments regarding the
      existence of impairment indicators are based on legal factors, market conditions
      and operational performance of our acquired businesses and
      investments.





In
      accordance with FASB Statement of Financial Accounting Standards No. 142
“Goodwill and Other intangible Assets” (SFAS 142), effective January 1, 2002,
      indefinite life intangible assets and goodwill are not amortized but rather
      subject to annual impairment testing.




Goodwill
      and intangible assets are tested for impairment by comparing the fair value
      of
      the reporting unit with its carrying value. Fair value is generally determined
      using discounted cash flows, market multiples and market capitalization.
      Significant estimates used in the fair value methodologies include estimates
      of
      future cash flows, future short term and long term growth rates, weighted
      average cost of capital and estimates of market multiples of the reportable
      unit. If these estimates or their related assumptions change in the future,
      we
      may be required to record impairment charges for our goodwill and intangible
      assets. These write downs, if any, may have an adverse affect on our operating
      results. Future events could cause us to conclude that impairment indicators
      exist and that additional intangible assets associated with our acquired
      businesses are impaired.




41





The
      process of evaluating the potential impairment of goodwill is subjective and
      requires significant judgment at many points during the analysis. In estimating
      the fair value of the reporting unit for the purpose of our annual or periodic
      analysis, we make estimates and judgments about the future cash flows of that
      reporting unit. Although our cash flow forecasts are based on assumptions that
      are consistent with our plans and estimates we are using to manage the
      underlying businesses, there is significant exercise of judgment involved in
      determining the cash flows attributable to a reporting unit over its estimated
      remaining useful life. In addition, we make certain judgments about allocating
      shared assets to the estimated balance sheets of our reporting units. Changes
      in
      judgment on these assumptions and estimates could result in a goodwill
      impairment charge. Any resulting impairment loss could have a material adverse
      impact on our financial condition and results of operations.





· *Income
      taxes.* Our
      income tax policy records the estimated future tax effects of temporary
      differences between the tax bases of assets and liabilities and amounts reported
      in the accompanying consolidated balance sheets, as well as operating loss
      and
      tax credit carry forwards. We follow specific and detailed guidelines regarding
      the recoverability of any tax assets recorded on the balance sheet and provide
      any necessary allowances as required in our management opinion, in accordance
      with the provisions of FASB Statement of Financial Accounting Standards No.
      109
“Accounting for Income Taxes.” If we fail to accurately predict our estimated
      tax and if we are required to pay higher taxes than we anticipated, our results
      of operations could be seriously harmed.





· *Accounts
      receivable* .
      We
      maintain a conservative method to assure the collection of our accounts
      receivable. Under this methodology, we periodically estimate the outstanding
      amounts and deduct an allowance for receivables with a low collection certainty.
      When there is a major deterioration of a customer’s credit worthiness, we make
      allowances for doubtful accounts upon specific review of all outstanding
      invoices of such customer. A relatively large portion of our revenue is
      generated from fixed-price-projects. We recognize revenue according to the
      percentage of completion method, and rely on project managers’ estimations in
      calculating that percentage. The customers’ payment terms are usually based on
      milestones. Therefore the delay in actual collection may reach 4-6 months.
      The
      average debt duration is approximately 2–3 months. If we fail to estimate
      accurately the recoverability of amounts due to us, our results of operations
      could be adversely affected.





· *Derivative
      Instruments* .
      We have
      adopted Statement of Financial Accounting Standards SFAS No. 133 “Accounting for
      Derivative Instruments and Hedging Activities” ("FAS 133"). Under the provisions
      of SFAS 133, all derivatives are recognized on the balance sheet at their fair
      value. Changes in fair value are recognized periodically in earnings or
      accumulated other comprehensive income within shareholders’ equity, depending on
      the intended use of the derivative and whether the derivative has been
      designated by management as a hedging instrument. Changes in fair value of
      derivative instruments not designated as hedging instruments are recognized
      in
      earnings in the current period.





We
      use
      foreign currency options, forward exchange contracts and forward interest
      contracts to assist in managing financial risks. We do not use derivative
      financial instruments for speculative purposes. These instruments are recognized
      at fair value, with all changes in fair value recorded in current period
      earnings, as these transactions have not been designated as hedging instruments
      under FAS 133.




42





We
      have
      an embedded conversion features as part of the $3 million convertible debenture
      host debt which is being marked to market and accounted in accordance with
      EITF
      00-19"Accounting for Derivative Financial Instruments Indexed to, and
      Potentially Settled In, a Company's Own Stock". In addition, we have convertible
      notes which consists an embedded put option which is bifurcated from the host
      debt and is being recorded at fair value in accordance with FAS
      133.





***Recently
      Issued Accounting Pronouncements:***





In
      February 2006, the FASB issued FAS 155, “Accounting for Certain Hybrid Financial
      Instruments, an Amendment of FASB Statements No. 133 and 140”. This
      statement permits fair value measurement for any hybrid financial instrument
      that contains an embedded derivative that otherwise would require bifurcation.
      This statement is effective for all financial instruments acquired or issued
      after the beginning of an entity’s first fiscal year that begins after
      September 15, 2006. We are currently evaluating the impact of this
      statement, if any, on our consolidated financial statements.





In
      July
      2006, the FASB issued FIN 48, “Accounting for Uncertainty in Income Taxes-an
      interpretation of FAS 109.” This financial interpretation clarifies the
      accounting for uncertainty in income taxes, and prescribes a recognition
      threshold and measurement attributes for the financial statement recognition
      and
      measurement of a tax position taken or expected to be taken in a tax return.
      FIN
      48 also provides guidance on various related matters such as the derecognition,
      interest and penalties and disclosure. As applicable to us, the interpretation
      prescribed by FIN 48 will be effective commencing January 1, 2007. We are
      currently evaluating the impact that the adoption of FIN 48 would have on our
      consolidated financial statements.





In
      September 2006, the FASB issued FAS 157, “Fair Value Measurements”. This
      standard establishes a framework for measuring fair value and expands related
      disclosure requirements; however, it does not require any new fair value
      measurement. As applicable to us, this statement will be effective as of the
      year beginning on January 1, 2008. We are currently evaluating the impact
      that the adoption of FAS 157 would have on our consolidated financial
      statements.





In
      September 2006, the SEC issued Staff Accounting Bulletin (SAB) 108, which
      expresses the Staff’s views regarding the process of quantifying financial
      statement misstatements. The bulletin is effective as of the year beginning
      January 1, 2006. The implementation of this bulletin had no impact on our
      consolidated financial statements.





In
      February 2007, the FASB issued FAS 159, “The Fair Value Option for Financial
      Assets and Financial Liabilities.” This standard permits entities to choose to
      measure many financial assets and financial liabilities at fair value.
      Unrealized gains and losses on items for which the fair value option has been
      elected are reported in earnings. As applicable to us, this statement will
      be
      effective as of the year beginning January 1, 2008. We are currently
      evaluating the impact that the adoption of FAS 159 would have on our
      consolidated financial statements.





43


In
        September 2006, the FASB issued SFAS No. 158, "Employers' Accounting for
        Defined Benefit Pension and Other Postretirement Plans—An Amendment of FASB
        No. 87, 88, 106 and 132(R)" ("SFAS 158"). SFAS 158 requires that
        the funded status of defined benefit postretirement plans be recognized on
        the
        balance sheet, and changes in the funded status be reflected in comprehensive
        income, effective fiscal years ending after December 15, 2006. The
        adoption of this statement did not have an impact on our consolidated
        financial statements.
 
 In
        December 2006, the FASB posted FASB Staff Position, or FSP,
        00-19-2, “Accounting for Registration Payment Arrangements.” This FSP specifies
        that the contingent obligation to make future payments or otherwise transfer
        consideration under a registration payment arrangement, whether issued as
        a
        separate agreement or included as a provision of a financial instrument or
        other
        agreement should be separately recognized and measured in accordance with
        FAS
        No. 5, “Accounting for Contingencies.” This FSP further clarifies that a
        financial instrument subject to a registration payment arrangement should
        be
        accounted for in accordance with other applicable GAAP without regard to
        the
        contingent obligation to transfer consideration pursuant to the registration
        payment arrangement. This FSP is effective immediately for registration payment
        arrangements and financial instruments subject to those arrangements that
        were
        entered into or modified subsequent to December 15, 2006. For registration
        payment arrangements and financial instruments subject to those arrangements
        that were entered into prior to December 15, 2006, the FSP is effective for
        fiscal years beginning after December 15, 2006, and interim periods within
        those fiscal years. We will adopt FSP
        00-19-2 beginning January 1, 2007 and we are currently evaluating the
        potential impact the adoption of this pronouncement will have on our
        consolidated financial statements.
 
 In
        November 2006, the FASB ratified EITF Issue No. 06-7," Issuer’s Accounting for a
        Previously Bifurcated Conversion Option in a Convertible Debt Instrument
        When
        the Conversion Option No Longer Meets the Bifurcation Criteria in FASB Statement
        No. 133, Accounting for Derivative Instruments and Hedging Activities" (“EITF
        06-7”). At the time of issuance, an embedded conversion option in a convertible
        debt instrument may be required to be bifurcated from the debt instrument
        and
        accounted for separately by the issuer as a derivative under FAS 133, based
        on
        the application of EITF 00-19. Subsequent to the issuance of the convertible
        debt, facts may change and cause the embedded conversion option to no longer
        meet the conditions for separate accounting as a derivative instrument, such
        as
        when the bifurcated instrument meets the conditions of Issue 00-19 to be
        classified in stockholders’ equity. Under EITF 06-7, when an embedded conversion
        option previously accounted for as a derivative under FAS 133 no longer meets
        the bifurcation criteria under that standard, an issuer shall disclose a
        description of the principal changes causing the embedded conversion option
        to
        no longer require bifurcation under FAS 133 and the amount of the liability
        for
        the conversion option reclassified to stockholders’ equity. In addition, under
        the EITF, for conversion of option for which the carrying amount has previously
        been reclassified to shareholders' equity, the issuer should recognize any
        unamortized discount remaining at the date of conversion immediately as interest
        expense. EITF 06-7 should be applied to all previously bifurcated conversion
        options in convertible debt instruments that no longer meet the bifurcation
        criteria in FAS 133 in interim or annual periods beginning after December
        15,
        2006, regardless of whether the debt instrument was entered into prior or
        subsequent to the effective date of EITF 06-7. Earlier application of EITF
        06-7
        is permitted in periods for which financial statements have not yet been
        issued.
        We are currently evaluating the impact of this guidance on our consolidated
        financial statements.
  44
  ***Our
        Reporting Currency***
 
 A
        substantial portion of our revenues and costs are denominated in United States
        dollars, or dollars. The dollar is the primary currency of the economic
        environment in which BluePhoenix operates. Thus the dollar is our functional
        and
        reporting currency. Accordingly, monetary accounts maintained in currencies
        other than the dollar are re-measured into dollars under the principles
        described in FASB Statement of Financial Accounting Standards No. 52. Assets
        and
        liabilities have been translated at period-end exchange rates. For non-dollar
        transactions reflected in the statements of operations, the exchange rates
        at
        transaction dates are used. For consolidated companies whose functional currency
        is other than the dollar, results of operations have been translated at
        appropriately weighted average exchange rates. The exchange gains and losses
        arising from these translations are included in the statement of income
        (loss).
 
 Following
        is a summary of the most relevant monetary indicators for the reported
        periods:
 
 **For the year ended**
                **December 31,**
              
              **Inflation rate in Israel**
              
              **Devaluation of NIS**
                **against the US$**
              
              **Devaluation of euro**
                **against the US$****%**
              
              **%**
              
              **%**2004
              
              
              1.2
              
              
              (1.6)
              
              
              (7.4)2005
              
              
              2.4
              
              
              6.8
              
              
              13.32006
              
              
              (0.1)
              
              
              (8.2)
              
              
              (11.3)
  45
  **A.**  **Operating
        Results** ****
 
 The
        following table presents the percentage relationships of certain items from
        our
        consolidated statement of operations, as a percentage of total revenues for
        the
        periods indicated:
 
 **Statement
        of Operations Data**
 **as
        a Percentage of Revenues:**
 
 **Year
                  ended December 31,****2006**
              
              **2005**
              
              **2004****%**
              
              **%**
              
              **%**Revenues
              
              
              100.0
              
              
              100.0
              
              
              100.0Cost
                  of revenues
              
              
              41.9
              
              
              43.1
              
              
              42.4Gross
                  profit
              
              
              58.1
              
              
              56.9
              
              
              57.6Software
                  development costs
              
              
              13.8
              
              
              13.6
              
              
              14.1Selling,
                  general, and administrative expenses
              
              
              32.6
              
              
              36.7
              
              
              37.4Operating
                  income
              
              
              11.7
              
              
              6.6
              
              
              6.1Financial
                  expenses, net
              
              
              (5.2
              )
              
              (3.3
              )
              
              (1.5
              )Gain
                  on realization of shareholdings
              
              
              -
              
              
              -
              
              
              0.1Other
                  income, net
              
              
              0.4
              
              
              0.2
              
              
              1.8Income
                  before taxes on income
              
              
              6.9
              
              
              3.5
              
              
              6.5Income
                  tax expense (income), net
              
              
              (0.4
              )
              
              0.3
              
              
              0.57.3
              
              
              3.2
              
              
              6.0Minority
                  interest
              
              
              (0.4
              )
              
              (0.2
              )
              
              (0.1
              )Equity
                  in losses of affiliated companies, net
              
              
              -
              
              
              -
              
              
              (0.9
              )Net
                  income
              
              
              6.9
              
              
              3.0
              
              
              5.0
 
 **Years
        Ended December 31, 2006 and 2005**
 
 *Revenues.* Revenues
        increased 15% from $58.9 million in 2005 to $68.0 million in 2006. Revenues
        generated from products grew 16% from $8.7 million in 2005 to $10.2 million
        in
        2006. Revenues from services grew 15% from $50.2 million in 2005 to $57.9
        million in 2006. The product mix has not changed in 2006. We attribute the
        revenue growth of our services and products to the same key factors.
 
 ·
              The
                  growing realization by major enterprises that are dependent on
                  legacy core
                  systems, of the inevitability of IT modernization to remain effective,
                  competitive and efficient.
 
 ·
              We
                  have expanded our product offering throughacquisitionsand internal development efforts. Tools such as Natural/ADABAS
                  to JAVA and
                  IMS migration were introduced during 2006 and were integrated into
                  BluePhoenix’s suiteof
                  solutions.
                  We constantly update our suite of Solutionsin
                  order to support a larger variety of languages, databases and platform
                  conversions.We
                  believe that, asa
                  result, IT service companies choose to license our technologies
                  for use in
                  modernization projects for their end
                  customers.
 
 ·
              We
                  have strengthened our sales team and devoted significant management
                  attention to increase market awareness and to establish a strong
                  reputation as a leader in the modernization market. We have also
                  increased
                  our marketing efforts through targeted exhibitions, an expanded
                  public
                  relations program, web and email marketing, online web casts and
                  other
                  lead generation campaigns. These have significantly contributed
                  to
                  increasing the interest in our products and solutions and have
                  helped to
                  drive the growth in revenues.
  46


We
      believe that these growth factors will continue to affect our revenues in year
      2007.





The
      price
      of a modernization project mainly depends on the number of lines of code to
      be
      converted, and is determined independently of the source and target platforms.
      As a result, the prices of our solutions do not fluctuate
      significantly.





We
      constantly update our suite of tools in order to support a larger variety of
      languages, databases and platform conversions. As a result, IT service companies
      choose to license our technologies for use in modernization projects for their
      end customers. Revenues generated from products grew from $8.7 million in 2005
      to $10.2 million in 2006, representing 15% of the overall revenues in each
      of
      these years.





The
      table
      below presents the breakdown of our revenues based on the location of our
      customers for the periods indicated:





**2006**
            
            **2005**
            
            **2004****%**
            ****
            **%**
            ****
            **%**United
                States
            
            
            22
            
            
            30
            
            
            36Europe
                (other than Denmark)
            
            
            42
            
            
            32
            
            
            28Denmark
            
            
            15
            
            
            21
            
            
            18Israel
            
            
            15
            
            
            14
            
            
            15Other
            
            
            6
            
            
            3
            
            
            3Total
            
            
            100
            
            
            100
            
            
            100





Relationships
      that we developed during previous years with several large European customers
      have matured and started to generate a growing stream of projects. As a result,
      our revenues in Europe grew from $15.9 million in 2004 to $18.6 million in
      2005
      and to $28.4 million in 2006.





In
      order
      to compensate for the decrease in our revenues generated in North America,
      we
      plan to expand our sales and marketing efforts in this market.





*Cost
      of revenues.* Cost of
      revenues consists of salaries, travel costs relating to projects and services
      rendered, amortization of capitalized software costs and fees paid to
      independent subcontractors. Cost of revenues increased 12% from $25.4 million
      in
      2005 to $28.5 million in 2006. Cost of revenues as a percentage of revenues
      decreased 1.2% from 43.1% in 2005 to 41.9% in 2006. The decrease in cost of
      revenues as a percentage of revenues was mainly due to the expansion of our
      offshore centers, a process that is expected to continue in 2007. During 2006,
      we increased the number of professional employees in our offshore centers by
      11%. These new employees enabled us to replace on-site facility employees,
      thus
      decreasing the number of relatively expensive technical experts. The reduction
      in costs in our offshore centers relative to the costs in our on-site facilities
      resulted in an average savings of 30%-50% per employee. In addition, as the
      degree of automation of our tools increases, the need for expert services
      decreases, and as a result our direct expenses decrease.


47


The
      total
      amount of amortization of intangible assets in 2006 was $7.1 million, compared
      to $5.5 million in 2005. This increase was related to the general release of
      developed modernization tools and the amortization of intangibles related to
      2006 acquisitions *.*





*Software
      development costs.* Software
      development costs, gross, consist of salaries and consulting fees that we pay
      to
      professionals engaged in the development of new software tools and related
      methodologies. Software development costs, net, consist of software development
      costs, gross, less development grants and capitalized software costs.





Software
      development costs, net, increased from $8.0 million in 2005 to $9.4 million
      in
      2006. As a percentage of revenues, software development costs, net remained
      at
      14%.





Software
      development costs, gross, increased from $16.3 million in 2005 to $17.4 million
      in 2006. As a percentage of revenues, software development costs, gross
      decreased to 25.6% in 2006 compared to 27.7% in 2005. This decrease was
      primarily due to the market release of developed modernization tools and a
      reduction in costs by using our offshore centers.





In
      the
      past few years, our development costs have been attributed to the development
      of
      our unique modernization suite of tools. Software development costs are charged
      to operations as incurred, unless capitalized according to SFAS 86. In 2006,
      we
      capitalized software development costs in an aggregate amount of $7.5 million
      compared to $8.0 million in 2005. During 2005 and 2006, we introduced several
      new solutions:




·
            BluePhoenix
                LogicMiner – Solution for Understanding and Mining COBOL
                Applications;


·
            BluePhoenix
                Redevelopment SOA – New Redevelopment Solution for Converting COBOL
                Applications to Java and C#; and


·
            Automated
                Tool for Converting ADABAS/Natural Applications to Java Using Rational
                databases.





*Selling,
      general and administrative expenses.* Selling,
      general and administrative expenses consist primarily of wages and related
      expenses, travel expenses, third party and sales people commissions, selling
      expenses, marketing and advertising expenses, rent, insurance, utilities,
      professional fees, and depreciation. Selling, general and administrative
      expenses increased from $21.6 million in 2005 to $22.1 million in 2006. During
      2006, our expanded marketing efforts lead to a significant growth in revenue
      and
      in number of new signed deals during 2007.





*Financial
      expenses, net.* Financial expenses in 2006 were $3.5 million compared to $2.0 million in 2005.
      The increase in financial expenses is mainly attributable to the issuance of
      convertible notes in February 2006 and convertible debentures in March 2006.
      The
      calculation of the discount amortization and the fair value adjustments of
      related financial instruments resulted in non-cash financial expenses. The
      non-cash expenses related to the convertible notes and debentures were $1.2
      million in 2006 compared to $556,000 in 2005. In addition, the increase in
      financial expenses was attributable to the increase of the company’s overall
      borrowings from banks.


48


*Other
      income, net.* Other
      income, net in 2006 was $282,000 compared to $104,000 in 2005. Other income
      in
      2006 consists of dividend received from Steps Ventures, An Israeli venture
      capital investment group, in which we hold 375,000 shares representing 3.75%
      of
      their outstanding share capital.





*Income
      tax expense, net.* In 2006,
      we had income from income tax, net of $282,000 compared to an expense of
      $149,000 in 2005. The income in 2006 was related to the final settlement of
      tax
      assessments with the Israeli Income Tax Authorities, which was partially offset
      by our local taxes paid worldwide by our international
      subsidiaries.





*Minority
      interests in profits of subsidiaries* .
      Minority interest in 2006 includes $204,000 representing the minority share
      in
      the profits of Mainsoft, $88,000 representing the minority share in the profits
      of Liacom Systems and $25,000 representing the minority share in the profits
      of
      Zulu Software Inc.





**Years
      Ended December 31, 2005 and 2004**





*Revenues.* Revenues
      increased 3% from $57.2 million in 2004 to $58.9 million in 2005. This increase
      was mainly in the second half of 2005 and reflects the consolidation of I-Ter
      results. The price of a modernization project mainly depends on the number
      of
      lines of code to be converted, and is determined independently of the source
      and
      target platforms. As a result, the prices of our solutions do not fluctuate
      significantly.





The
      increase in sales in Europe is partially attributable to our marketing efforts
      during 2005, which resulted in a 19% increase in revenues in Europe (including
      Denmark) in 2005 compared to 2004. In addition, the consolidation of I-Ter
      contributed to our annual revenue growth in Europe. In the United States there
      was a decrease of 15% in revenues in 2005 compared to 2004. This decrease is
      mainly attributable to a delay in new orders from the North American market
      during the first half of 2005.





*Cost
      of revenues.* Cost of
      revenues increased 4.6% from $24.3 million in 2004 to $25.4 million in 2005.
      Cost of revenues as a percentage of revenues increased 0.7% from 42.4% in 2004
      to 43.1% in 2005. The increase in cost of revenues was caused by the increased
      amount of amortization of intangible assets that reached technical feasibility
      during 2005. The total amount of amortization of intangible assets in 2005
      was
      $5.5 million, compared to $3.1 million in 2004. This increase was mostly offset
      by a decline in salaries and project related costs, due to the efficient usage
      of our offshore delivery centers.





*Software
      development costs.* Software
      development costs, gross, increased 4% from $15.6 million in 2004 to $16.3
      million in 2005. As a percentage of revenues, software development costs, gross
      was not changed materially, 27.7% in 2005 compared to 27.3% in 2004.





In
      the
      past few years, our development costs were attributed to the development of
      our
      unique modernization suite of tools. Software development costs are charged
      to
      operations as incurred, unless capitalized according to SFAS 86. In 2005, we
      capitalized software development costs in an aggregate amount of $8.0 million
      compared to $7.1 million in 2004. This increase was primarily due to the
      implementation of our strategy to expand our tool offerings and increase the
      degree of automation of our tools. These factors are important in order to
      maintain our leadership position in the market and perform profitable
      projects.


49





*Selling,
      general and administrative expenses.* Selling,
      general and administrative expenses increased from $21.4 million in 2004 to
      $21.6 million in 2005. During 2005, our management members devoted significant
      marketing efforts in order to further expose the Company’s suite of tools to
      potential customers and partners.





*Financial
      income (expenses), net.* Financial expenses in 2005 were $2.0 million compared to $882,000 in 2004.
      A
      portion of the increase in financial expenses is due to the issuance of
      convertible debentures in March 2004, which was partially included in financial
      expenses in 2004 and fully accounted for in the first quarter of 2005, when
      a
      registration statement covering the underlying shares became effective. In
      addition, the increase in financial expenses is attributable to (i) the increase
      of the company’s overall borrowings from banks, and (ii) the devaluation of the
      euro conversion rate compared to the dollar in 2005 by 13.3%, as compared to
      a
      7.4% increase in the euro conversion rate in 2004.





*Gain
      on realization of shareholdings.* There
      was no gain on realization of shareholdings in 2005. Gain on realization of
      shareholdings in 2004 was $112,000. This gain results from a sale of ordinary
      shares of Cicero Inc. was $171,000. This gain was partially offset by a loss
      of
      $59,000 resulted from transaction-related costs with respect to the sale of
      our
      shareholdings in Tesnet – Software Testing Ltd., or Tesnet. The sale of Tesnet’s
      shares was for cash consideration of $2.8 million.





*Other
      income, net.* Other
      income, net in 2005 was $104,000 compared to $975,000 in 2004. Other income
      in
      2004 consists primarily of a $703,000 dividend received from Steps
      Ventures.





*Income
      tax expense.* In 2005,
      we had an income tax expense of $149,000 compared to $260,000 in 2004. Due
      to
      tax losses carried forward in Israel and in several other locations, our total
      tax expense is composed of the net aggregate expense of local taxes paid
      worldwide by our international subsidiaries.





*Share
      in losses of affiliated companies, net.* In 2004,
      share in losses of affiliated companies, net, was $516,000. Share in losses
      of
      affiliated companies in 2004 was mainly attributable to $69,000 representing
      our
      share in the losses of Intercomp, and $455,000 representing our share in the
      losses of MultiConn Technologies. In 2005, these two affiliates were
      consolidated in our result of operations, and therefore no equity in losses
      of
      affiliated companies was recorded.





*Minority
      interests in profits of subsidiaries* .
      Minority interest in 2005 includes $137,000 representing the minority share
      in
      the profits of Mainsoft, and $2,000 representing the minority share in the
      profits of Liacom Systems.


50


B.Liquidity
      and Capital Resources





**How
      We Have Financed Our Business**





In
      1997,
      we consummated two public offerings, and received net proceeds of $33.9 million
      after deducting underwriting discounts and commissions and offering expenses.





On
      March
      30, 2004, we completed a $5 million private placement to institutional
      investors. Under the terms of this transaction as amended on February 18, 2005,
      we issued to the institutional investors convertible debentures due in 2007,
      bearing interest at a rate of six months LIBOR paid quarterly. Pursuant to
      our
      agreement with the institutional investors, in March 2006, the institutional
      investors exercised their right to purchase from us additional convertible
      debentures and warrants for an aggregate purchase price of $3 million. Those
      debentures are due in 2009.





As
      of
      March 22, 2007, $4.4 million principal amount of the debentures were converted
      into 929,475 BluePhoenix ordinary shares. For more information regarding the
      private placement, see “– Contractual Commitments and Guarantees.”





In
      February 2006, we completed an underwritten public offering in Israel of series
      A convertible notes in an aggregate principal amount NIS 54.0 million that
      were
      equal at that time to approximately $11.5 million . The price of the notes
      as
      determined in the offering was 98% of the principal amount of the notes, and
      the
      gross proceeds from the offering were $11.2 million. The notes bear an interest
      at a rate of LIBOR 3 months +1.5% per annum, payable every 3 months beginning
      on
      May 1, 2006, with the last payment to be made on February 1, 2011. The principal
      of the notes is payable in four equal annual installments on February 1 of
      each
      of 2008 through 2011. Under certain terms, we may call for an early redemption
      of the notes, after February 1, 2008. The notes are convertible into ordinary
      shares of BluePhoenix at a conversion rate of one ordinary share per NIS 26
      ($6.15) principal amount of notes, subject to adjustments. Holders may convert
      their notes into BluePhoenix’s ordinary shares on any trading day, beginning on
      the date the notes were first listed for trading and until the close of trading
      on January 16, 2011, except for certain specified days. The convertible notes
      are not secured.





As
      of
      March 22, 2007, NIS 402,000 principal amount of the notes (approximately
      $96,000) were converted into 15,474 BluePhoenix ordinary shares.





The
      notes
      are traded on the TASE. The notes and the shares underlying the notes have
      not
      been registered under the Securities Act, and may not be offered or sold in
      the
      United States or to U.S. persons, absent registration or an applicable exemption
      from registration requirements.


51




We
      have
      entered into credit facilities with Bank Discount Le’Israel Ltd., Bank Ha’Poalim
      Ltd. Bank Leumi Le’Israel Ltd. and the First International Bank Ltd., of up to
      an aggregate of $33.5 million. The aggregate amount outstanding under these
      credit facilities as of December 31, 2006 was $22.2 million, and as of March
      22,
      2007 was $22.1 million. We used these credit facilities to finance certain
      acquisitions, to give guarantees, and for interim financing, in accordance
      with
      our cash requirements. A portion of the credit lines were used in 2006 to
      finance the acquisitions of CodeStream and Zulu. See item 4 B" Investment and
      Acquisitions". These credit facilities provide for loans in various currencies
      and bear various interest rates. In connection with these credit facilities
      extended to us by these banks, we are committed to certain covenants related
      to
      our operations, such as:





·
            maintaining
                a minimum level of shareholders’ equity of no less than 40% of our total
                assets and no less than $40
                million;


·
            maintaining
                a level of annual operating income before depreciation and amortization
                of
                no less than $5 million; and


·
            maintaining
                a ratio of our bank liabilities to current assets, excluding other
                current
                assets, of no more than 55%.





To
      date,
      we have met all such covenants.





On
      December 31, 2006, we had cash and cash equivalents (including marketable
      securities) of $12.7 million and working capital of $17.9 million. On December
      31, 2005, we had cash and cash equivalents of $10.8million and working capital
      of $4.5 million.





Net
      cash
      provided by operating activities was $10.0 million in 2006 compared to $5.2
      million in 2005. Cash provided by operating activities improved in 2006 as
      compared to 2005 primarily as a result of an increase in net income. In
      addition, there was an increase in cash flow due to certain down payments from
      customers. This increase was partially offset by increased accounts receivables
      that were a result of extended payment terms to several long-term customers
      who
      placed repeat large purchase orders.




Typical
      modernization projects, which deploy our solutions, are long-term projects,
      and
      therefore, payment for these projects or a substantial portion of our fees
      may
      be delayed until the successful completion of specified milestones and customer
      acceptance for the completed work. During 2004, we mutually agreed with a
      customer, to terminate a contract. The contract was accounted for under the
      percentage of completion method. As a result, we recorded a loss of $400,000
      in
      the first quarter of 2004. The payment of our fees is generally dependent upon
      customer acceptance of the completed work, and our ability to collect the fees.
      Further, although the timing of receipt of our fees varies, we incur the
      majority of our expenses on a current basis. As a result, a delay in the
      collection of our fees could result in cash flow shortages.




***Capital
      Expenditures***




Our
      capital expenditures were $676,000 in 2006 and $700,000 in 2005. Our capital
      expenditures in these years related primarily to purchases of computers and
      related equipment required to support our software development activities.
      In
      2005, we invested $370,000 in other companies.


52




In
      December 2006, we purchased the activities of CodeStream for a consideration
      of
      $10.2 million. For more information about the CodeStream transaction, see “Item
      4.B. Business Overview – Investments and Acquisitions –CodeStream.”





In
      the
      last three years, we did not repurchase any shares under our buy-back programs.
      As of December 31, 2006, we had repurchased 1,870,565 of our ordinary shares
      under our buy-back programs, for an aggregate of approximately $14.7 million.
      In
      January 2006, we sold an aggregate of 136,000 of the shares held by one of
      our
      subsidiaries to Israeli institutional investors in Israel, for aggregate
      consideration of approximately $534,000. In February 2006, we sold 86,971 shares
      held by one of our subsidiaries to Outlook Systems Ltd.; see “Item 4.B. Business
      Overview – Investments and Acquisitions – Outlook.” Under our buy-back programs,
      we may purchase our shares from time to time, subject to market conditions
      and
      other relevant factors affecting us. Under the Companies Law, the repurchased
      shares do not confer upon our subsidiaries any voting rights (although they
      entitle their holders to participation rights upon distribution). The first
      buy-back program adopted in May 1998 enables us to purchase our shares, through
      a subsidiary, utilizing up to $5.0 million. Under the second buy-back program
      adopted in September 1998, and amended in May 1999, we may purchase, through
      a
      subsidiary as a trustee, up to an additional 2,000,000 ordinary shares. Under
      the two plans we may acquire an additional 854,455 shares at the current stock
      price. The closing price of our ordinary shares as quoted on the NASDAQ Global
      Market on March 22, 2007 was $6.84. Under the agreement we entered into in
      connection with the private placement in March 2004, we are restricted to use
      only up to $200,000 for the repurchase of our shares, as long as 20% or more
      of
      the debentures are outstanding.





We
      believe that cash generated from operations together with existing sources
      of
      liquidity and cash flow, will be sufficient to meet our anticipated cash needs
      for at least the next 18 months.





**Contractual
      Commitments and Guarantees**




*Convertible
      Debentures Issued in a Private Placement to Institutional
      Investors*





On
      March
      30, 2004, we completed
      a $5 million private placement of convertible debentures and warrants to four
      institutional investors. On February 18, 2005, the institutional investors
      and
      we amended certain terms of the transaction. Pursuant to the amended agreements,
      the debentures are due in 2007 and bear interest at a rate equal to the
      six-month LIBOR, paid quarterly in cash or in a number of BluePhoenix ordinary
      shares, at our discretion. The debentures are convertible into BluePhoenix’s
      ordinary shares at a conversion rate of $5.25 per ordinary share, subject to
      (i)
      adjustment for stock dividends, stock splits, recapitalization and other similar
      events; and (ii) anti-dilution adjustments. Following an event of adjustment
      in
      January 2006, the conversion rate of the debentures was adjusted to $5.24 per
      ordinary share. The conversion rate with respect to payments of interest on
      the
      debentures will be equal to 90% of the volume weighted average price of our
      ordinary shares on the NASDAQ Global Market during the 20 trading days preceding
      the date of payment of interest. In the event the volume weighted average price
      per ordinary share (as calculated in the preceding sentence) for any 20
      consecutive trading days exceeds $6.55, then we may force the holders of the
      debentures to convert any or all of the principal amount of the debentures
      held
      by them as of such date, subject to, among other things, our having an effective
      resale registration statement at such time for the resale of the ordinary shares
      underlying the debentures. As of March 22, 2007, subsequent to conversion of
      some of the debentures, we issued to the investors 262,808 ordinary shares.


53


In
      addition to the debentures, the institutional investors were issued warrants
      to
      purchase up to 285,714 BluePhoenix ordinary shares at an exercise price of
      $6.50
      per share, subject to adjustments similar to those pertaining to the conversion
      price of the debentures. The warrants are exercisable during a 5 years period
      commencing in September 2004.





Pursuant
      to our agreement with the institutional investors, in March 2006, three of
      the
      investors exercised their right to purchase from us additional debentures and
      warrants. Accordingly, we issued to the investors debentures at an aggregate
      purchase price of $3 million on the same terms as the initial debentures, except
      that the conversion price is $4.50 per share and due in 2009. As of March 22,
      2007, subsequent to conversion of the debentures, we issued to the investors
      666,667 ordinary shares. In addition, the institutional investors were issued
      additional warrants on the same terms as the initial warrants, to purchase
      an
      aggregate of up to 200,000 of our ordinary shares. The warrants are exercisable
      during a 5 years period commencing in September 2006.





As
      agreed
      with the investors, we registered the shares underlying the debentures and
      warrants for resale under an effective registration statement.





*Series
      A Convertible Notes Offered to the Public in Israel*





In
      February 2006, we completed an underwritten public offering in Israel of series
      A convertible notes in an aggregate principal amount of NIS 54.0 million that
      were equal at that time to approximately $11.5 million. Interest on the notes
      is
      LIBOR 3 months +1.5% per annum. The interest is payable every 3 months beginning
      on May 1, 2006, with the last payment to be made on February 1, 2011. The
      principal of the notes is payable in four equal annual installments on February
      1 of each of 2008 through 2011. The notes are convertible into BluePhoenix’s
      ordinary shares at a conversion rate of one ordinary share per NIS 26 ($6.15)
      principal amount of notes. The notes are traded on the TASE. For
      more
      information regarding the series A convertible notes, see “Item 5.B. Liquidity
      and Capital Resources-How Have We Finances Our Business.”





Under
      funding agreements, three of our subsidiaries have entered into with the Office
      of the Chief Scientist (OCS), these subsidiaries are obliged to pay royalties
      to
      the OCS at a rate of 3% on sales of the funded products, up to 100% of the
      dollar-linked grant received in respect of these products from the OCS. As
      of
      December 31, 2006, the aggregate amount of grants received by our subsidiaries
      from the OCS was $2.5 million.





In
      the
      first quarter of 2004, the Singapore-Israel Industrial Research and Development
      Foundation agreed to provide one of our wholly owned subsidiaries together
      with
      a company incorporated in Singapore, financing for the development of a Java
      report generator software tool. Accordingly, the foundation agreed to award
      our
      subsidiary up to $100,000 payable according to an agreed upon schedule. As
      of
      March 22, 2007, we received $45,000 of the grant. The grant is required to
      be
      repaid in installments based on sales of the funded software up to the amount
      of
      the grant.


54




Our
      subsidiary, I-Ter, is entitled to funds to develop Easy4Plan product, from
      the
      Ministry of Production in Italy. Easy4Plan is a workflow management tool
      designed for ISO9000 companies. Approximately 30% of the funds are a grant,
      and
      the balance is an 8-year loan to be repaid by I-Ter. The loan bears a minimal
      annual interest. The development term ended in September 2006. Pending the
      final
      approval of the Ministry of Production, we anticipate that during 2007 I-Ter
      will receive a total aggregate amount of approximately $650,000.




We
      are
      obligated to pay to Formula management fees in an annual amount equal to 3%
      of
      our revenues, but no more than the NIS equivalent of $180,000. For more
      information see “Item 7. Major Shareholders and Related Party Transactions –
Related Party Transactions – Management Agreement with Formula.”





Under
      agreements between us and certain of our customers, we undertook to provide
      such
      customers bank guarantees for the assurance of performance of our obligations
      under our agreements with such customers. As of March 22, 2007, there are
      outstanding bank guarantees on our behalf for our customers in the aggregate
      amount of $420,000.





We
      are
      committed under operating leases for rental of office facilities, vehicles
      and
      other equipment for the years 2007 until 2011. Annual rental fees under current
      leases are approximately $3.1 million, and are expected to remain at this level
      for each of the next three years. In connection with the office leases, we
      issued bank guarantees of $107,000 in the aggregate.





We
      entered into an undertaking to indemnify our office holders in specified limited
      categories of events and in specified amounts, subject to certain limitations.
      For more information, see “Item 7.B. Related Party Transactions –
Indemnification of Office Holders.”





***Effective
      Corporate Tax Rates***





In
      1996,
      1997 and 1998, certain of our operations were granted “approved enterprise”
status under the Law for the Encouragement of Capital Investments – 1969,
      known as the Investments Law. If we comply with all requirements, we shall
      be
      eligible for certain tax benefits with respect to these operations, for the
      first seven years in which they generate taxable income. Undistributed income
      derived from our approved enterprise programs will be exempt from corporate
      tax
      for a period of two years after we have taxable income, and will be subject
      to a
      25% corporate tax rate for the following five years. We completed the tax
      exemption period of some of our qualified “approved enterprise” operations and,
      therefore, these operations are subject to a 25% income tax commencing 1999.
      If
      the percentage of our share capital held by foreign shareholders exceeds 25%,
      future approved enterprises would qualify for reduced tax rates for an
      additional three years, after the seven years mentioned above. However, we
      cannot assure you that we will obtain additional “approved enterprise” status
      for our operations, or that the provisions of the Investments Law will not
      change, or that the above-mentioned shareholding portion will be reached or
      maintained for each subsequent year.


55




On
      January 1, 2003, Israel’s tax laws underwent a significant tax reform (Amendment
      132 to the Income Tax Ordinance (New Version) – 1961). The legislation broadened
      the categories of taxable income, and reduced the tax rates imposed on
      employment income. Among the key provisions of this legislation were (i) changes
      that may result in the imposition of taxes on dividends received by an Israeli
      company from its foreign subsidiaries; and (ii) the introduction of the
      controlled foreign corporation concept according to which an Israeli company
      may
      become subject to Israeli taxes on certain income of a non-Israeli subsidiary
      if
      the subsidiary’s primary source of income is passive income (such as interest,
      dividends, royalties, rental income or capital gains). An Israeli company that
      is subject to Israeli taxes on the income of its non-Israeli subsidiaries will
      receive a credit for income taxes paid by the subsidiary in its country of
      residence.





On
      January 1, 2006, an additional tax reform has been taken place relating
      primarily to profits from investments. The main goal of the reform was to unify
      the tax rates applicable to profits from investments, such as interest, capital
      gains and dividends. In addition, under the new reform, the tax rates applicable
      to companies were reduced to 31% in 2006, 29% in 2007, 27% in 2008, 26% in
      2009
      and 25% in 2010.





Our
      international operations are taxed at the local effective corporate tax rate
      in
      the countries of our subsidiaries’ residence. We believe that in the future we
      will derive an increasing percentage of our income from operations outside
      of
      Israel and that, accordingly, our effective tax rate may increase. However,
      we
      expect that this increase will be offset by carried forward accumulated losses
      of consolidated companies. As a result, we anticipate that our net effective
      tax
      rate in the foreseeable future shall be lower than 25%.




**C.**  **Research
      and Development, Patents and Licenses**





For
      a
      description of our research and development activities, see “Item 4.B. Business
      Overview – Research and Development.”





For
      information concerning our intellectual property rights, see “Item 4.B. Business
      Overview – Intellectual Property.”




**D.**  **Trend
      Information** ****





We
      have
      been affected by global economic changes, in particular the sharp decline in
      2001 and 2002, in capital spending in the IT sector and the overall business
      slowdown in North America and Europe, as well as in Israel. Uncertainties in
      the
      North American and European markets have influenced the purchasing patterns
      of
      leading software developers who delayed their planned orders and caused
      developers to reduce the amount of their planned license commitment. These
      changes in purchasing patterns in the IT industry directly affect our operating
      results. In 2006, we generated $4.7 million net income from our operations.
      However, in 2002 and 2001 we had a net loss of $3.6 million and $15.0 million,
      respectively. The net loss in 2002 and 2001 was a reversal from prior years
      in
      which we had net income. We cannot know how the economic conditions will
      continue to affect our business. As we continue to market new products and
      penetrate international markets, we expect our selling, general and
      administrative expenses to continue to be relatively high.


56


**E.**  **Off-Balance
      Sheet Arrangements**





For
      information relating to contingent consideration in certain acquisitions, see “ Item
      4.B.
      Business Overview – Investments and Acquisitions – CodeStream, Outlook, I-Ter, CePost. ”




**F.**  **Tabular
      Disclosure of Contractual Obligations** ****





The
      following table summarizes our contractual obligations and commitments as of
      December 31, 2006:





**Payment
                due by period****Total**
            
            **Less than**
              **1 year**
            
            **1–3**
              **years**
            
            **4–5**
              **years**
            
            **More**
              **than 5**
              **years**In
                thousands $Long
                term debt obligations
            
            
            34,075
            
            
            -
            
            
            24,469
            
            
            9,607
            
            
            -Operating
                lease obligations
            
            
            5,741
            
            
            3,063
            
            
            2,749
            
            
            44
            
            
            -**Total**
            
            
            39,816
            
            
            3,063
            
            
            27,218
            
            
            9,651
            
            
            -





The
      above
      table does not include interest payments and royalties that we may be required
      to pay to the OCS and that may reach, in the aggregate, as of December 31,
      2006,
      $2.5 million. For more information about grants received from the OCS, see
“Item
      4.B. Business Overview – Research and Development.” We are unable to
      reasonably estimate the amounts that we will eventually be required to pay
      to
      the OCS, if at all, and the timing of such payments, since these payments depend
      on our ability to sell products based on the OCS-funded technologies and the
      timing of such sales, if any.




**G.**  **Safe
      Harbor**





The
      safe
      harbor provided in Section 27A of the Securities Act and Sections 21E of the
      Exchange Act shall apply to forward-looking information provided in Items 5.E
      and F.




**ITEM
      6. DIRECTORS, SENIOR MANAGEMENT, AND EMPLOYEES**




**A.**  **Directors
      and Senior Management**





The
      following table describes information about our executive officers and directors
      as of March 22, 2007 **.**





**Name**
            
            **Age**
            
            **Position**Gad
                Goldstein
            
            48
            
            Chairman
                of the BoardArie
                Kilman
            
            54
            
            Chief
                Executive Officer, DirectorIris
                Yahal
            
            46
            
            Chief
                Financial Officer, DirectorShai
                Beilis
            
            58
            
            DirectorNaamit
                Salomon
            
            42
            
            DirectorAaron
                Crystal
            
            63
            
            DirectorGur
                Shomron(1)
            
            54
            
            DirectorGuy
                Bernstein
            
            39
            
            DirectorMichael
                Chill(1)
            
            40
            
            DirectorAmira
                Berkovitz-Amir(1)
            
            40
            
            Director


________________


(1)
            An
                outside director


57





**Gad
      Goldstein** has
      served as a chairman of our board of directors since April 1998. Mr. Goldstein
      was the vice president of Formula from 1985 through 1995, and was appointed
      president and chief executive officer of Formula in 1995. Mr. Goldstein served
      as a director of Formula from January 1985 through December 2006. He is also
      a
      director of other companies within the Formula Group, including Matrix IT Ltd.,
      Magic Software Enterprises Ltd., or Magic, and Sapiens International Corporation
      N.V., all of which are publicly traded companies. Mr. Goldstein also serves
      as a
      director of Formula Vision Technologies (F.V.T.) Ltd. Mr. Goldstein holds a
      BA
      in economics and an MA in business administration, both from Tel Aviv
      University.





**Arie
      Kilman** has
      served as our chief executive officer since May 2003. Mr. Kilman has also served
      as president and chief executive officer of BluePhoenix Solutions B.V. since
      its
      inception in October 2001. Mr. Kilman previously served as the president of Liraz,
      which he founded in 1984, and managed since then. From 1998 to July 2000, Mr.
      Kilman served as chief executive officer of Level 8. Mr. Kilman holds a BA
      degree in economics and computer science from New York University.





**Iris
      Yahal** has
      served as one of our directors since January 1, 1999 and as our chief financial
      officer since October 1995. In addition, Ms. Yahal served as the controller
      of
      several other Formula subsidiaries until December 1996. From 1991 until 1996,
      Ms. Yahal served as the controller of Transtech Control Ltd., a subsidiary
      of
      Formula. Prior to 1991, Ms. Yahal worked as an auditor with Wallenstein and
      Co.,
      a public accounting firm. Ms. Yahal holds a BA in accounting and an MA in
      business administration, both from Tel Aviv University, and is a certified
      public accountant in Israel.





**Shai
      Beilis** served
      as chairman of our board of directors from December 1995 until April 1998 and
      as
      vice chairman of our board of directors from April 1998 until November 1999.
      Mr.
      Beilis continues to serve as one of our directors. Mr. Beilis currently serves
      as chairman and chief executive officer of Formula Ventures Ltd., a venture
      capital fund manager. Mr. Beilis also served as a director of Formula from
      December 1997 until February 2005. From July 1993 until the beginning of 1995,
      Mr. Beilis served as the managing director of Clal Computers and Technology
      Ltd., an Israeli information technology company traded on TASE. Mr. Beilis
      holds
      a B.Sc. in mathematics and economics from the Hebrew University in Jerusalem
      (cum laude) and an MA in computer science from the Weizmann Institute of
      Science.





**Naamit** **Salomon** joined
      our board of directors in December 2004. Ms. Salomon has served as vice
      president, finance of Formula since August 1997. Ms. Salomon also serves as
      a
      director of Magic and Sapiens International Corporation N.V. From 1990 through
      August 1997, Ms. Salomon was a controller of two privately held companies in
      the
      Formula Group. Ms. Salomon holds a BA in economics and business administration
      from Ben Gurion University and an LLM from Bar-Ilan University.


58





**Aaron
      Crystal** founded
      our company (previously named Crystal System Solutions Ltd.) in 1987, and served
      as our chief executive officer through 1996 and president through March 2005.
      Mr. Crystal has served as one of our directors since our formation. Between
      November 1999 and December 2004, he also served as vice chairman of our board
      of
      directors. From 2004, Mr. Crystal has served as chairman of the board of a
      privately held software company, Cogniview Ltd. From 1983 to 1987 Mr. Crystal
      was vice president, technical support of Mehish Computer Services.





**Gur
      Shomron** joined
      our board of directors and appointed as a member of our audit committee in
      July
      2005. Mr. Shomron serves as the chairman of the board of directors of Fidelis
      Diagnostics Inc. since 2004. Prior to that, Mr. Shomron served as Venture
      Partner at StageOne VC fund. Mr. Shomron is also a management consultant for
      Bet
      Israel 101 Ltd. and serves as a director of our subsidiary, Mainsoft, and of
      several other privately-held high technology companies.





**Guy
      Bernstein** joined
      our board of directors in December 2006. Mr. Bernstein is the chief executive
      officer and member of the board of directors of Emblaze Ltd., a major
      shareholder of Formula. Prior to that, from April 2004, Mr. Bernstein has served
      as chief financial officer of Emblaze. Between 1999 and 2004, Mr. Bernstein
      served as chief financial and operations officer of Magic. He also acted as
      the
      interim chief executive officer for subsidiaries of Magic, MSE Israel Ltd.
      and
      Coretech Consulting Group. From 1994 to 1997, Mr. Bernstein acted as senior
      manager at Kost Forer Gabbay & Kasierer, a member of Ernst & Young
      Global. Mr. Bernstein holds a BA in accounting and economics from Tel-Aviv
      University and is a certified public accountant in Israel.





**Michael
      Chill** has
      served as one of our outside directors and a member of our audit committee
      since
      July 2003. From July 2005, Mr. Chill has served as Co-head of the Direct
      Investments at Paramount Biocapital Asset Management Inc, a venture capital
      hedge fund and broker dealer. Prior to that, Mr. Chill served as an analyst
      and
      independent advisor to various high technology companies and venture capital
      firms both in Israel and the United States. During 2000 and the first half
      of
      2001, Mr. Chill served as the president and head of investment banking
      department at Jerusalem Global Ltd., a venture capital and investment banking
      firm. Prior to that, from 1999, Mr. Chill served as a managing director in
      the
      technology investment banking group at Gruntal and Co. Mr. Chill holds a B.S.
      in
      accounting from the Sy Syms School of Business at Yeshiva University and an
      MBA
      from the Columbia Business School.





**Amira
      Berkovitz -Amir** has
      served as one of our outside directors and as a member of our audit committee
      since December 2004. From March 2007, Ms. Berkovitz-Amir is the director of
      finance of the Baruch Padeh Medical Center, Poriya. Until October 2005, Ms.
      Berkovitz-Amir served as vice president, finance of Of-Tov Products (2001)
      Ltd.,
      a manufacturer in the food industry and a member of Osem Industries Group.
      Previously, Ms. Berkovitz-Amir served as vice president, finance and controller
      of Pri-Hagalil Industries, a manufacturer in the food industry. Ms.
      Berkovitz-Amir holds a BA degree in economics and accounting and an MA in
      business administration, both from the Hebrew University. Ms. Berkovitz-Amir
      is
      a certified public accountant in Israel.


59




**B.**  **Compensation** ****





In
      2006,
      we paid to our outside directors and executive officers aggregate remuneration
      of approximately $642,227. This amount includes bonuses and amounts set aside
      or
      accrued to provide pension, social security or similar benefits but does not
      include amounts expended by us for automobiles made available to our officers
      and expenses (including business travel, professional and business association
      dues and expenses) reimbursed to officers. Under Israeli law, we are not
      required to disclose, and have not otherwise disclosed, the compensation of
      our
      senior management and directors on an individual basis.





The
      aggregate remuneration set forth in the foregoing paragraph does not include
      amounts we paid to Formula under the terms of a management agreement, as
      consideration for management services rendered to us by certain directors
      designated by Formula. These directors currently include Gad Goldstein, Guy
      Bernstein and Naamit Salomon. See “Item 7.B. Related Party
      Transactions.”





We
      maintain written employment agreements with Arie Kilman and Iris Yahal. The
      employment agreements are not for a specific term and we may terminate any
      of
      them upon prior notice of between three and six months. If we terminate any
      of
      these employment agreements, we will have to pay the usual severance pay
      required under Israeli law for all employees. The directors are not entitled
      to
      any other benefits upon termination. These agreements provide for annual base
      salaries and other benefits like vacation, sick leave, provision of automobiles,
      insurance contributions, and non-compete and confidentiality agreements. The
      agreements also entitle Mr. Kilman and Ms. Yahal to bonuses based on achieving
      targets set by our board of directors.





Mr.
      Kilman, in his former position as Liraz’s chairman of the board of directors was
      granted by Liraz, in May 2002, a loan in an amount equal to approximately
      $300,000, linked to the Israeli consumer price index, and bearing annual
      interest at a rate of 4%. Under the terms of the loan, the loan was repaid
      to
      Liraz in four equal annual installments, the last one of which was made in
      2006.
      Mr. Kilman has fully complied with all loan payment obligations under the loan
      agreement.




**C.**  **Board
      Practices**





Pursuant
      to our articles of association, directors are elected at a general meeting
      of
      our shareholders by a vote of the holders of a majority of the voting power
      represented at the meeting. Additional directors may be elected between general
      meetings by a majority of our directors. Our board is comprised of 10 persons,
      of which 3 have been determined to be independent within the meaning of the
      applicable NASDAQ requirements. Two of these independent directors also serve
      as
      outside directors mandated under Israeli law and subject to additional criteria
      to help ensure their independence. See “Outside Directors,” below. Each
      director, except for the outside directors, holds office until the next annual
      general meeting of shareholders. Officers are appointed by our board of
      directors.


60





Our
      board
      of directors has appointed an option committee, comprised of Messrs. Gad
      Goldstein, Shai Beilis and Amira Berkovitz-Amir. The option committee is
      responsible for granting options to employees.




The
      compensation of our executive officers is determined by independent members
      of
      our board of directors. The compensation of officers that requires the approval
      of the audit committee or any other additional approval under applicable law,
      is
      also brought for such entities’ additional approval .




Companies
      trading on The NASDAQ Stock Market are generally required to have a majority
      of
      their board members be independent. We are exempt from this requirement under
      the “controlled company” exemption because more than 50% of our voting power is
      held by Formula.





***Outside
      Directors***





Under
      the
      Companies Law, 1999, referred to as the Companies Law, companies incorporated
      under the laws of Israel whose shares have been offered to the public in or
      outside of Israel, are required to appoint at least two outside directors.
      The
      Companies Law provides that a person may not be appointed as an outside director
      if the person or the person’s relative, partner, employer or any entity under
      the person’s control, has, as of the date of the person’s appointment to serve
      as outside director, or had, during the two years preceding that date, any
      affiliation with the company or any entity controlling, controlled by or under
      common control with the company. The term “affiliation” includes:





·
            an
                employment relationship;


·
            a
                business or professional relationship maintained on a regular
                basis;


·
            control;
                and


·
            service
                as an office holder.





No
      person
      may serve as an outside director if the person’s position or other business
      activities create, or may create a conflict of interest with the person’s
      responsibilities as an outside director or may otherwise interfere with the
      person’s ability to serve as an outside director or if the person is an employee
      of the Israel Securities Authority or of an Israeli stock exchange. If, at
      the
      time of election of an outside director, all other directors are of the same
      gender, the outside director to be elected must be of the other gender. Outside
      directors are elected by a majority vote at a shareholders’ meeting, provided
      that either:





(1)
            the
                majority of shares voted at the meeting, including at least one-third
                of
                the shares of non-controlling shareholders or their representatives
                voted
                at the meeting, vote in favor of election;
                or


61


(2)
            the
                total number of shares of non-controlling shareholders voted against
                the
                election of the outside director does not exceed one percent of the
                aggregate voting rights in the
                company.





Pursuant
      to the Companies Law, all outside directors must have financial and accounting
      expertise or professional qualifications, and at least one outside director
      must
      have financial and accounting expertise. The terms “financial and accounting
      expertise” and “professional qualifications” have been defined in regulations
      promulgated under the Companies Law.





The
      initial term of an outside director is three years and may be extended for
      an
      additional three years. At present, Mr. Michael Chill and Ms. Amira
      Berkovitz-Amir serve as our outside directors, Mr. Chill to hold office until
      July 2009 and Ms. Berkovitz-Amir until December 2007. Under a recent amendment
      to the Israeli Companies Regulations (Alleviation for Public Companies Whose
      Shares are Listed on a Stock Exchange Outside of Israel) 2000, dual listed
      companies, like us, may re-appoint an outside director for an additional
      three-year term, above the maximum six-year term permitted under the Companies
      Law, if the audit committee and the board of directors confirm that due to
      the
      expertise and special contribution of the outside director to the work of the
      board and its committees, his re-appointment is in the best interests of the
      company.





Each
      committee exercising the powers of the board of directors is required to include
      at least one outside director. However, the audit committee should include
      all
      the outside directors.





An
      outside director is entitled to compensation as provided in regulations
      promulgated under the Companies Law and is otherwise prohibited from receiving
      any compensation, directly or indirectly, in connection with services provided
      as an outside director. We compensate our two outside directors in accordance
      with regulations promulgated under the Companies Law.





***Qualifications
      of Other Directors***





Under
      the
      Companies Law, the board of directors of a publicly traded company is required
      to make a determination as to the minimum number of directors who must have
      financial and accounting expertise according to criteria that is defined in
      regulations promulgated under the Companies Law. In accordance with the
      Companies Law, the determination of the board should be based on, among other
      things, the type of the company, its size, the volume and complexity of its
      activities and the number of directors. Based on the foregoing considerations,
      our board determined that the number of directors with financial and accounting
      expertise in our company shall not be less than two.





**Audit
      Committee**





The
      Companies Law requires public companies to appoint an audit committee, comprised
      of at least three directors, which must include all of the company’s outside
      directors. The chairman of the board of directors, any director which is
      employed or provides services to the company, and a controlling shareholder
      or
      any relative of a controlling shareholder, may not be a member of the audit
      committee.


62


In
      addition, under applicable NASDAQ rules, we are currently required to have
      at
      least three independent directors and to maintain an audit committee, whose
      members are independent of management. Our outside directors qualify as
      independent directors under the applicable NASDAQ rules and those of the
      Securities and Exchange Commission. We have established an audit committee,
      consisting of our two outside directors, Mr. Michael Chill and Ms. Amira
      Berkovitz-Amir, as well as Mr. Gur Shomron, who is considered “independent”
under the applicable NASDAQ rules. The board has determined that both Michael
      Chill and Amira Berkovitz-Amir are “audit committee financial experts” as
      defined by applicable SEC regulations.





Under
      the
      Companies Law, the audit committee is responsible for overseeing the business
      management practices of the company in consultation with the company’s internal
      auditor and the independent auditor, making recommendations to the board to
      improve such practices and approving related party transactions as required
      by
      the Companies Law. In accordance with the Sarbanes-Oxley Act and NASDAQ
      requirements, our audit committee is directly responsible for the appointment,
      compensation and oversight of our independent auditors. In addition, the audit
      committee is responsible for assisting the board in monitoring our financial
      statements and the effectiveness of our internal controls. We have adopted
      a
      formal audit committee charter that we have implemented, embodying these
      responsibilities. The audit committee reviews and reassesses the adequacy of
      the
      audit committee charter on an annual basis.





***Internal
      Auditor***





Under
      the
      Companies Law, the board of directors appoints an internal auditor, nominated
      by
      the audit committee. The role of the internal auditor is to examine, among
      other
      matters, whether the company’s actions comply with the law and orderly business
      procedure. Under the Companies Law, the internal auditor may be an employee
      of
      the company but not an office holder, or an interested party (defined as a
      holder of 5% or more of the voting rights in the company or of its issued share
      capital, the chief executive officer of the company or any of its directors,
      or
      a person who has the authority to appoint the company’s chief executive officer
      or any of its directors), or a relative of an office holder or of an interested
      party. In addition, the company’s external auditor or its representative may not
      serve as the company’s internal auditor.





***Approval
      of Certain Transactions under the Companies Law***





The
      Companies Law codifies the fiduciary duties that “office holders,” including
      directors and executive officers, owe to a company. An office holder’s fiduciary
      duties consist of a duty of care and a duty of loyalty. The duty of loyalty
      includes (i) avoiding any conflict of interest between the office holder’s
      position in the company and his personal affairs; (ii) avoiding any competition
      with the company; (iii) avoiding exploiting any business opportunity of the
      company in order to receive personal advantage for himself or others; and (iv)
      revealing to the company any information or documents relating to the company’s
      affairs that the office holder has received due to his position as an office
      holder. Each person listed in the table under “Directors and Senior Management”
above is an office holder.


63


Under
      the
      Companies Law, arrangements regarding the compensation of directors require
      the
      approval of the audit committee, the board of directors and shareholder
      approval.





The
      Companies Law requires that an office holder of a company promptly disclose
      any
      personal interest that he or she may have and all related material information
      known to him or her, in connection with any existing or proposed transaction
      by
      the company. In addition, if the transaction is an “extraordinary transaction”
as defined under the Companies Law, the office holder must also disclose any
      personal interest held by the office holder’s spouse, siblings, parents,
      grandparents, descendants, spouse’s descendants and the spouses of any of the
      foregoing. In addition, the office holder must also disclose any interest held
      by any corporation in which the office holder owns 5% or more of the share
      capital, is a director or general manager or in which he or she has the right
      to
      appoint at least one director or the general manager. An “extraordinary
      transaction” is defined as a transaction other than in the ordinary course of
      business, otherwise than on market terms or that is likely to have a material
      impact on the company’s profitability, assets or liabilities.





Under
      the
      Companies Law, after the office holder complies with the disclosure requirements
      described above, only board approval is required for any transaction that is
      not
      an extraordinary transaction, unless the articles of association of the company
      provide otherwise, and provided the transaction is not adverse to the company’s
      interest. If the transaction is an extraordinary transaction, the company must
      receive any approval stipulated by its articles of association, the approval
      of
      the audit committee, the approval of the board of directors and shareholder
      approval. An office holder who has a personal interest in a matter that is
      considered at a meeting of the board of directors or the audit committee may
      not
      be present at this meeting or vote on this matter unless the majority of the
      board members or members of the audit committee, as applicable, have a personal
      interest in such matter and in such case, the matter should also be approved
      by
      the shareholders of the company.





The
      Companies Law applies the same disclosure requirements to a controlling
      shareholder of a public company, including a shareholder that holds 25% or
      more
      of the voting rights in the company if no other shareholder owns more than
      50%
      of the voting rights in the company. Extraordinary transactions with a
      controlling shareholder or in which a controlling shareholder has a personal
      interest, and the terms of compensation of a controlling shareholder or its
      relative who is an office holder or an employee of the company, require the
      approval of the audit committee, the board of directors and the shareholders
      of
      the company. The shareholder approval must include at least one-third of the
      shareholders who have no personal interest in the transaction and are voting
      on
      the subject matter or, alternatively, the total shareholdings of those who
      have
      no personal interest in the transaction who vote against the transaction must
      not represent more than one percent of the voting rights in the company. In
      certain cases provided in regulations promulgated under the Companies Law,
      shareholder approval is not required.





The approvals of the board of directors and shareholders are required for a private
      placement of securities (or a series of related private placements during a
      12-month period or that are part of one continuous transaction or transactions
      conditioned upon each other) in which:




·
            the
                securities issuedrepresent at least 20% of the company’s actual voting power prior to the
                issuance of such securities, and such issuance increases the relative
                holdings of a 5% shareholder or causes any person to become a 5%
                shareholder, and the consideration in the transaction (or a portion
                thereof) is not in cash or in securitieslistedon
                a recognized stock exchange, or is not at a fair market value;
                or




64




·
            a
                person would become, as aresultof
                such transaction, a controlling shareholder of the
                company.





Under
      the
      Companies Law, a shareholder has a duty to act in good faith towards the company
      and other shareholders and to refrain from abusing his power in the company
      including, among other things, voting in a general meeting of shareholders
      on
      the following matters:





·
            any
                amendment to the articles of
                association;


·
            an
                increase of the company’s authorized share
                capital;


·
            a
                merger; or


·
            approval
                of interested party transactions that require shareholder
                approval.





In
      addition, any controlling shareholder, any shareholder who knowingly possesses
      power to determine the outcome of a shareholder vote and any shareholder who,
      pursuant to the provisions of a company’s articles of association, has the power
      to appoint or prevent the appointment of an office holder in the company, is
      under a duty to act with fairness towards the company. The Companies Law does
      not describe the substance of this duty.





For
      information concerning personal interests of certain of our office holders
      and
      our principal shareholders in certain transactions with us, see “Item 7.B.
      Related Party Transactions.”





***Exculpation,
      Insurance and Indemnification of Directors and
      Officers***




Under
      the
      Companies Law, an Israeli company may not exempt an office holder from liability
      with respect to a breach of his duty of loyalty, but may exempt in advance
      an
      office holder from his liability to the company, in whole or in part, with
      respect to a breach of his duty of care, provided, however, that such a breach
      is not related
      to a distribution of a dividend or any other distribution by the
      company .





*Office
      Holders Insurance*





Our
      articles of association provide that, subject to the provisions of the Companies
      Law, we may enter into a contract for insurance of all or a part of the
      liability of any of our office holders imposed on the office holder in respect
      of an act performed in his or her capacity as an office holder, in respect
      of
      each of the following:





·
            a
                breach of his duty of care to us or to another
                person;


·
            a
                breach of his duty of loyalty to us, provided that the office holder
                acted
                in good faith and had reasonable cause to assume that such act would
                not
                prejudice our interests; or


·
            a
                financial obligation imposed on him or her in favor of another
                person.




65




*Indemnification
      of Office Holders*





Our
      articles of association provide that, subject to the provisions of the Companies
      Law, we may indemnify our office holders in respect of an obligation or expense
      specified below imposed on an office holder in respect of an act performed
      in
      his or her capacity as an office holder, as follows:





(i)  a
      financial obligation imposed on him or her in favor of another person by a
      court
      judgment, including a compromise judgment or an arbitrator’s award approved by
      court;





(ii)  reasonable
      litigation expenses, including attorney’s fees, incurred by the office holder as
      a result of an investigation or proceeding instituted against the office holder
      by a competent authority, provided that such investigation or proceeding
      concluded without the filing of an indictment against the office holder; and
      either (a) concluded without the imposition of any financial liability in lieu
      of a criminal proceeding; or (b) a financial liability was imposed on him in
      lieu of a criminal proceeding for an offense that does not require proof of
      criminal intent; and





(iii)  reasonable
      litigation expenses, including attorney’s fees, expended by the office holder or
      charged to the office holder by a court, in a proceeding instituted against
      the
      office holder by the company or on its behalf or by another person, or in a
      criminal charge from which the office holder was acquitted, or in a criminal
      proceeding in which the office holder was convicted of an offense that does
      not
      require proof of criminal intent.





We
      may
      undertake to indemnify an office holder as aforesaid, (a) prospectively,
      provided that in respect of (i) above, the undertaking is limited to categories
      of events that in the opinion of our board of directors are foreseeable in
      light
      of the company’s operations at the time that the undertaking to indemnify is
      given, and for an amount or criteria that our board has determined as reasonable
      under the circumstances, and further provided that that such events and amount
      or criteria are indicated in the indemnification undertaking; and (b)
      retroactively.





We
      have
      entered into an undertaking to indemnify our office holders in specified limited
      categories of events and in specified amounts, subject to the limitations set
      by
      the Companies Law and our articles of association, as described above. For
      more
      information, see “Item 7.B. Related Party Transactions – Indemnification of
      Office Holders.”




*Limitations
      on Exemption, Insurance and Indemnification*





The
      Companies Law provides that a company may not indemnify an office holder, enter
      into an insurance contract that would provide coverage for any monetary
      liability, or exempt an office holder from liability, with respect to any of
      the
      following:




66




·
            a
                breach by the office holder of his duty of loyalty, except that the
                company may indemnify or provide insurance coverage to the office
                holder
                if the office holder acted in good faith and had a reasonable basis
                to
                believe that the act would not prejudice the
                company;


·
            a
                breach by the office holder of his duty of care if the breach was
                done
                intentionally or recklessly, except for a breach that was made in
                negligence;


·
            any
                act or omission done with the intent to derive an illegal personal
                benefit; or


·
            any
                fine levied against the office
                holder.





In
      addition, under the Companies Law, indemnification of, and procurement of
      insurance coverage for, our office holders must be approved by our audit
      committee and our board of directors and, in specified circumstances, by our
      shareholders.





We
      have
      procured directors’ and officers’ liability insurance and obtained all necessary
      approvals.




**D.**  **Employees**





The
      table
      below presents certain information regarding the number of our employees, the
      sector in which they are employed and their geographical area of employment,
      in
      the periods indicated.





**2006**
            
            **2005**
            
            **2004**Technical
                Experts
            
            
            335
            
            
            260
            
            
            290Research
                and Development
            
            
            150
            
            
            140
            
            
            160Sales,
                General and Administrative
            
            
            130
            
            
            120
            
            
            110**Total**
            
            
            **615**
            
            
            **520**
            
            
            **560**In
                Israel
            
            
            246
            
            
            211
            
            
            223In
                Europe
            
            
            284
            
            
            253
            
            
            234In
                the United States
            
            
            85
            
            
            56
            
            
            103





The
      numbers of employees indicated in the table above include expert consultants
      who
      we train for the implementation of our modernization tools and
      methodologies.





With
      respect to our employees in Israel, we are subject to various Israeli labor
      laws
      and labor practices, and to administrative orders extending certain provisions
      of collective bargaining agreements between the Histadrut (Israel’s General
      Federation of Labor) and the Coordinating Bureau of Economic Organizations
      (the
      Israeli federation of employers’ organizations) to all private sector employees.
      For example, mandatory cost of living adjustments, which compensate Israeli
      employees for a portion of the increase in the Israeli consumer price index,
      are
      determined on a nationwide basis. Israeli law also requires the payment of
      severance benefits upon the termination, retirement or death of an employee.
      We
      meet this requirement by contributing on an ongoing basis towards “managers’
insurance” funds that combine pension, insurance and, if applicable,
      severance-pay benefits. In addition, Israeli employers and employees are
      required to pay specified percentages of wages to the National Insurance
      Institute, which is compatible with the United States Social Security
      Administration. Other provisions of Israeli law and regulations govern matters
      such as the length of the workday, minimum wages, other terms of employment
      and
      restrictions on discrimination. We are also subject to the labor laws and
      regulations of other jurisdictions in the world where we have employees.


67




**E.**  **Share
      Ownership**





The
      following presents information regarding the ownership of our ordinary shares
      by
      the persons listed in the table under “Directors and Senior Management,” as of
      March 22, 2007. The percentage of outstanding ordinary shares is based on
      15,374,124 ordinary shares outstanding as of March 22, 2007 (excluding 1,647,594
      shares held by two of our wholly owned subsidiaries).





Unless
      otherwise specifically indicated, the address of each of the persons set forth
      below is at c/o BluePhoenix, 8 Maskit Street, Herzlia 46120.





**Name**
            
            **Shares
                beneficially owned**(1)**Number**
            
            **Percentage of
                outstanding**
              **ordinary shares**
            
            **Options to purchase**
              **ordinary shares**
              **Number**Arie
                Kilman(2)
            
            
            564,999(3)
            
            
            3.7%
            
            
            725,000(1)Gad
                Goldstein
            
            
            230,628
            
            
            1.5Aaron
                Crystal
            
            
            587,000
            
            
            3.8Shai
                Beilis
            
            
            —
            
            
            —Iris
                Yahal
            
            
            —
            
            
            —
            
            
            45,000(4)Naamit
                Salomon
            
            
            —
            
            
            —Gur
                Shomron
            
            
            —
            
            
            —Guy
                BernsteinMichael
                Chill
            
            
            —
            
            
            —Amira
                Berkovitz-Amir
            
            
            —
            
            
            —All
                directors and officers as a group(10
                persons)(3)(5)
            
            
            2,152,627
            
            
            13.3
            
            
            770,000





(1)
            Each
                of the directors and executive officers whose holdings are not separately
                specified in the above table beneficially owns less than one percent
                of
                our outstanding ordinary shares. Options to purchase ordinary shares
                that
                are currently exercisable or exercisable within 60 days after the
                date of
                this report are deemed outstanding and beneficially owned by the
                person
                holding the options for the purpose of computing the percentage ownership
                of that person, but are not treated as outstanding for the purpose
                of
                computing the percentage ownership of any other person.




(2)
            Mr.
                Kilman was granted options to purchase ordinary shares under the
                following
                terms: (i) currently exercisable options to purchase 375,000 ordinary
                shares at $2.25 per share, which expire in April 2013; (ii) currently
                exercisable options to purchase 200,000 ordinary shares exercisable
                at
                $4.00 per share, currently exercisable which expire in September
                2013; and
                (iii) currently exercisable options to purchase 150,000 ordinary
                shares at
                $6.00 per share, which expire in September
                2015.




(3)
            Includes
                294 shares that Anat Crystal, Mr. Crystal’s
                spouse, beneficially owns.




68




(4)
            Mrs.
                Yahal was granted options to purchase ordinary shares under the following
                terms:


(i)
                currently exercisable options to purchase 10,000 ordinary shares
                exercisable at $5.50 per share, which expire in October 2010; and
                (ii)
                currently exercisable options to purchase 35,000 ordinary shares
                at $5.00
                per share, which expire in December
                2015.




(5)
            Includes
                currently exercisable options to purchase 770,000 ordinary shares,
                held by
                two of our directors who are also
                officers.





***Arrangements
      Involving the Issuance of BluePhoenix*** ***’*** ***s
      Shares or Grant of Options to Purchase Shares***




In
      1996,
      we adopted two option plans. One of these option plans has been terminated
      after
      all options granted under it had been exercised. **** Pursuant
      to our other 1996 option plan, as amended, we reserved 3,700,000 ordinary shares
      for issuance to our and our subsidiaries’ directors, officers, consultants and
      employees. As of March 22, 2007, options to purchase 2,145,017 ordinary shares
      were outstanding under the plan. The exercise price of the options granted
      under
      the 1996 option plan ranges from $2.25 to $10.50.





Our
      board
      of directors administers our 1996 option plan. Under the 1996 option plan,
      as
      amended, options to purchase our ordinary shares may be granted to our and
      our
      subsidiaries’ directors, officers, consultants and employees. Our board of
      directors is empowered, among other things, to designate the grantees, dates
      of
      grant, the exercise price of the options and the terms of exercise of the
      options. Unless determined otherwise by the board, the options generally vest
      over a three-year period. Unvested options are forfeited shortly following
      termination of employment, unless otherwise agreed. Under the 1996 option plan,
      the grantee is responsible for all personal tax consequences of the grant and
      the exercise of the options. Each option granted under the 1996 option plan
      is
      exercisable during a term of ten years from the date of grant of the option.
      The
      1996 option plan will expire on August 6, 2013, except as to options outstanding
      on that date.





In
      anticipation of the effect of the adoption of Statement of Accounting Standard
      No. 123R, or SFAS 123R, and under the management belief that in the currently
      increasing competition in the labor market, an acceleration may have a positive
      effect on employee morale and retention, our board of directors and compensation
      committee approved as of December 27, 2005, the acceleration of several
      outstanding unvested options under our 1996 option plan so as to be fully-vested
      as of such date (see Notes 1J and 11B1 to our financial statements). As a
      result, options to purchase 144,900 BluePhoenix ordinary shares and options
      to
      purchase 1,228,997 shares of Mainsoft, were accelerated. The acceleration of
      options held by our officers who also serve as directors of the company, was
      also approved by the company’s shareholders as required under the
      law.


69


**ITEM
      7. MAJOR SHAREHOLDERS AND RELATED PARTY TRANSACTIONS**




**A.**  **Major
      Shareholders** ****





The
      following table presents information regarding the ownership of our ordinary
      shares at March 22, 2007 by each person known to us to be the beneficial owner
      of 5% or more of our ordinary shares. Options to purchase ordinary shares that
      are currently exercisable or exercisable within 60 days after the date of this
      report are deemed outstanding and beneficially owned by the person holding
      the
      options for the purpose of computing the percentage ownership of that person,
      but are not treated as outstanding for the purpose of computing the percentage
      ownership of any other person. Except where we indicated otherwise, we believe,
      based on information furnished by these owners, that the beneficial owners
      of
      our shares listed below have sole investment and voting power with respect
      to
      the shares.





**Name
                  and Address**
              
              **Number**
              
              **Percent****(1)**Formula
                  Systems (1985) Ltd.
              
              
              8,038,526(2)
              
              
              52.3%(2)Aaron
                  Crystal
              
              
              587,000(3)
              
              
              3.8%Arie
                  Kilman
              
              
              1,289,999(4)
              
              
              8.0%(5)





(1)
            Unless
                otherwise indicated, percentages in the above table are based on
                15,374,124 ordinary shares outstanding as of March 22, 2007, and
                do not
                include 1,647,594 ordinary shares that two of our subsidiaries hold.
                Pursuant to Israeli law, these shares do not confer upon our subsidiaries
                any voting rights (although such shares entitle their holders to
                participation rights upon distribution). In January 2006, we sold
                136,000
                shares held by one of our subsidiaries to Israeli institutional investors
                in Israel. In February 2006, we sold 86,971 shares held by one of
                our
                subsidiaries to Outlook Systems Ltd. For more information about the
                sale
                of our shares to Outlook Systems, see“Item
                4.B. Business Overview–Investments and Acquisitions–Outlook.”




(2)
            Emblaze
                Ltd. owns 42.4% of the outstanding share capital of Formula. Messrs.
                Naftali Shani and Eli Reifman, directors of Emblaze Ltd., hold 13.8%
                and
                9.4% of the outstanding share capital of Emblaze Ltd., respectively.
                Our
                chairman of the board, Gad Goldstein, is a president and chief executive
                officer of Formula and owns 2.5% of the outstanding shares of
                Formula.




(3)
            Includes
                294 shares that Anat Crystal, Mr. Crystal’s
                spouse, beneficially owns. During 2004 through March 22, 2007, Mr.
                Crystal
                sold 337,038 ordinary shares in the open market.




(4)
            Includes
                currently exercisable options to purchase 725,000 ordinary shares.
                The
                percentage of holdings includes those options.




(5)
            Percentage
                is calculated based on 16,144,124 ordinary shares outstanding, which
                include currently exercisable options to purchase 770,000 ordinary
                shares
                held by Mr. Kilman.





All
      of
      our ordinary shares have equal voting rights. Under our two buy-back programs
      (as described in “ Item
      5.B.
      Liquidity and Capital Resources ” above),
      two of our subsidiaries purchased 1,870,565 of our ordinary shares, of which
      136,000 shares were sold in January 2006 to Israeli institutional investors
      in
      Israel and 86,971 shares were sold in February 2006 to Outlook Systems Ltd.
      Under applicable Israeli law, so long as the shares are held by our
      subsidiaries, they have no voting rights but such shares confer upon their
      holder ’ s
      participation rights upon distribution.


70





As
      of  March
      8,
      2007, there were  31  record
      holders of our ordinary shares. Of these record holders,  16
      holders had mailing addresses in the United States owning an aggregate less
      than
      1% of our outstanding ordinary shares, excluding the shares that our
      subsidiaries hold. As of  December
      6, 2006 we had approximately  1,558  beneficial
      shareholders .





**B.**  **Related
      Party Transactions** ****





*Management
      Agreement with Formula*





On
      January  1,
      1996,
      we signed a letter agreement with Argotec Ltd., at that time our parent company
      wholly owned by Formula, pursuant to which Formula provides us with
      administrative and management support. Under the agreement, Formula provides
      three of our directors, including our chairman of the board, who is active
      in
      the direction of our business. Additionally, Formula arranges to have certain
      volume discounts extended to us as part of Formula ’ s
      control
      group, and Formula provides us with administrative services, including services
      relating to insurance, human resources, global planning, real property leasing,
      and the department of motor vehicles.





Pursuant
      to the letter agreement, we pay Formula in return for its services, a management
      fee equal to 3.0% of our revenues, up to a maximum of $180,000 per year. The
      amount of management fee was negotiated between us and Argotec in 1996 when
      we
      initially entered into the letter agreement. The amount of the fee was
      determined primarily on the parties ’ good
      faith estimates of the value of services to be provided by the three directors
      seconded to us by Formula and the extent of our expected cost savings to be
      generated by Formula ’ s
      assistance in obtaining volume discounts and the provision of administrative
      support. Although we did not engage in actual negotiations with potential
      third-party providers of comparable services, the fee was based in part on
      our
      market knowledge of the cost of obtaining such services from third parties
      and/or developing the internal resources necessary to carry out these functions
      ourselves.





We
      pay
      the management fee to Formula in installments at the end of each quarter. For
      the year ended December 31, 2006, a management fee of $180,000 was payable
      to
      Formula under this agreement, representing 0.3% of our revenues in 2006. In
      addition, we reimburse Formula from time to time for expenses Formula incurred
      on our behalf.





For
      more
      information regarding the positions that some of our directors hold in Formula
      and their holdings in Formula’s shares, see “Item 6.A. Directors and Senior
      Management” and “Item 7.A. Major Shareholders.”





*Cooperation
      with Matrix*





We
      have
      been cooperating with Matrix IT Ltd., a subsidiary of Formula, in performance
      of
      modernization projects in Israel and license agreements since 1996. In 2006,
      we
      renewed the legal terms of our cooperation with Matrix by signing a cooperation
      agreement. In 2006, revenues from sales through Matrix amounted to $1.2
      million.


Matrix
        also serves as a subcontractor in several projects we perform. In 2006, the
        aggregate amount paid by us to Matrix subcontractors was $1.2
        million.


71







*Registration
      Rights Agreements*





In
      1997,
      we entered into a registration rights agreement with Formula, Dan
      Goldstein, Aaron Crystal and two additional shareholders, referred to
      collectively as the holders. Under this registration rights agreement, the
      holders have certain registration rights with respect to their ordinary shares.
      We agreed that, beginning January 31, 1998, at the request of the holders of
      a
      majority of the shares held by the persons and entities who signed the
      agreement, and on no more than two occasions, we will file a registration
      statement under the Securities Act for an offering of their shares with respect
      to which registration is requested. In addition, if we otherwise propose to
      register our ordinary shares under the Securities Act, these holders may request
      that we register their shares as well, subject to certain limitations. We shall
      bear all fees and expenses in connection with the registration, except that
      the
      holders will pay all fees and expenses of their own counsel and all underwriting
      discounts and commissions relating to their shares. As of March 22, 2007, the
      holders did not exercise their rights pursuant to the agreement.





In
      October 2002, we granted certain registration rights to Formula, Mr. Arie Kilman
      and another shareholder of Liraz in the Share Exchange Agreement with those
      shareholders. Under this agreement, if we propose to register our ordinary
      shares under the Securities Act, each of these holders may request that we
      register their shares as well, subject to certain limitations.  We
      shall
      bear all expenses in connection with the registration, provided that all
      underwriting commissions shall be paid by the holders selling shares with
      respect to their shares sold.





In
      May
      2004, our board of directors approved to include 400,000 BluePhoenix’s shares
      held by certain directors and officers in a registration statement filed by
      us
      on June 1, 2004 and declared effective on March 15, 2005.





In
      December 2006, we granted CodeStream certain registration rights with respect
      to
      shares underlying convertible debentures to be issued to CodeStream or its
      successors. Under this agreement, subject to certain conditions, we agreed
      that,
      at the request of the holders of a majority of the shares underlying each of
      the
      debentures, given within 10 business days after issuance of the debenture,
      we
      will file a registration statement under the Securities Act for an offering
      of
      the shares underlying the debenture. In addition, if we otherwise propose to
      register our ordinary shares under the Securities Act, the holders of the
      debentures may request that we register their shares as well, subject to certain
      limitations. In the event that holders of 50% or more of the principal amount
      of
      a debenture request repayment of the debenture prior to its due date, we will
      be
      released from the obligations described above. For more information about the
      transaction with CodeStream, see “Item 4.B. Business Overview–Investments and
      Acquisitions–CodeStream.”





*Transactions
      Between Us and Our Subsidiaries*





We
      currently hold 40% of the outstanding share capital of MultiConn Technologies
      and have an option to increase our holdings in MultiConn Technologies to 60%.
      As
      of March 22, 2007, we lent to MultiConn Technologies an aggregate amount of
      $2.5
      million. For more information about M.S.I. MultiConn and MultiConn Technologies,
      see “Item 4.B. Business Overview–Investments and
      Acquisitions–MultiConn.”


72





In
      2000,
      we entered into a management agreement with Mainsoft, under which we provide
      Mainsoft with management and advisory consulting services. Until the end of
      2005, Mainsoft paid us in exchange for our services aggregate consideration
      of
      $120,000 per year. Beginning with 2006, the management fees were reduced to
      $60,000 per year.





In
      February 2005, we entered into an alliance agreement with Zulu for cooperation
      in marketing and selling Zulu’s and our software tools and services. For more
      information about Zulu, see “Item 4.B. Business Overview–Investments and
      Acquisitions–Zulu.”




*Transactions
      between Us and Our Chief Executive Officer*





Mr.
      Kilman, in his former position as Liraz’s chairman of the board of directors,
      was granted by Liraz, in May 2002, a loan in an amount equal to approximately
      $300,000. As of March 22, 2006, Mr. Kilman repaid the entire amount of the
      loan,
      including principal, linkage differentials and accrued interest. For more
      information relating to the loan granted to Mr. Kilman, see “Item 6.B.
      Compensation.”





*Services
      Agreement with TIS*





In
      January 2006, we entered into a services agreement with TIS Ltd., or TIS, a
      Cypriot company. Under the agreement, TIS provides us with consulting and other
      professional services. When we signed the agreement with TIS, 38.8% of the
      share
      capital of TIS was held by CTI Ltd., or CTI, a Cypriot company. Mr. Kilman,
      our
      chief executive officer and director, held a 49% interest in CTI. Therefore,
      the
      transaction was considered as a related party transaction and we obtained the
      necessary approvals required under Israeli law. In November 2006, Mr. Kilman
      notified us that CTI sold the shares it held in TIS and it was no longer a
      shareholder of TIS. In 2006, fees paid to TIS amounted to $300,000.





*Indemnification
      of Office Holders*





Since
      July 2003, we grant to our office holders’ indemnification letters covering acts
      performed in their capacity as office holders or employees of our company.
      On
      December 27, 2005, our shareholders approved an amendment to those
      indemnification letters, following a recent amendment to the Companies Law.
      Pursuant to the amended indemnification letters, we undertake to indemnify
      each
      office holder to the maximum extent permitted by law in respect of the following
      for any act or omission taken or made by the office holder in his or her
      capacity as an office holder of our company:





·
            any
                financial obligation imposed on the office holder in favor of another
                person by a court judgment, including a settlement or an arbitrator’s
                award approved by court,





·
            all
                reasonable litigation expenses, including attorney’s fees, expended by the
                office holder as a result of an investigation or proceeding instituted
                against the office holder by a competent authority, provided that
                such
                investigation or proceeding concluded without the filing of an indictment
                against the office holder and either (a) concluded without the imposition
                of any financial liability in lieu of criminal proceedings; or (b)
                concluded with the imposition of a financial liability in lieu of
                criminal
                proceeding but relates to a criminal offense that does not require
                proof
                of*mens
                rea*(criminal
                intent); and





73




·
            all
                reasonable litigation expenses, including attorney’s fees, expended by the
                office holder or charged to him or her by a court in a proceeding
                instituted against the office holder by us or on our behalf or by
                another
                person, or in any criminal proceedings in which the office holder
                is
                acquitted, or in any criminal proceedings of a crime that does not
                require
                proof of*mens
                rea*(criminal intent) in which the office holder is
                convicted.





The
      indemnification also applies to any action taken by the office holder in respect
      of an act performed in his or her capacity as an office holder or an employee
      of
      one of our subsidiaries or as a director or observer at board of directors’
meetings of one of our affiliates. Our undertaking for indemnification is
      limited to up to 25% of our shareholders’ equity at the time of the claim for
      indemnification.





Our
      undertaking for indemnification does not apply to a liability incurred as a
      result of any of the following:





·
              a
                  breach by the office holder of his or her duty of loyalty, unless,
                  to the
                  extent permitted by law, the office holder acted in good faith
                  and had
                  reasonable cause to assume that such act would not prejudice the
                  interests
                  of our company;


·
                  a
                      willful breach by the office holder of his or her duty of care,
                      unless
                      such breach was solely due to
                      negligence;


·
              an
                  action taken or not taken with the intent of unlawfully realizing
                  personal
                  gain;


·
              a
                  fine or penalty imposed on the office holder for an offense;
                  and


·
              a
                  counterclaim made by us in connection with a claim against us filed
                  by the
                  office holder.





Our undertaking
        for indemnification is limited to such events specified in the indemnification
        letter and determined by our board of directors to be foreseeable in light
        of
        the company’s operations.





Under
      the
      indemnification letters, we exempt our office holders to the fullest extent
      permitted by law, from liability for damages caused as a result of a breach
      by
      the office holder of his or her duty of care to the company.




*Office
      Holders Insurance*





We
      procured an insurance policy covering our directors’ and officers’ liability.
      Our subsidiaries participate in the premium payments of the insurance, on a
      proportional basis. The total premium we paid during 2006 was approximately
      $50,000.





74




**C.**  **Interests
      of Expert and Counsel**





Not
      applicable.




**ITEM
      8. FINANCIAL INFORMATION**




**A.**  **Consolidated
      Statements and Other Financial Information**





***Financial
      Statements***





The
      financial statements required by this item are found at the end of this annual
      report, beginning on page F-1.





***Legal
      Proceedings***





We
      are
      not involved in any proceedings in which any of our directors, members of our
      senior management or any of our affiliates is either a party adverse to us
      or to
      our subsidiaries or has a material interest adverse to us or to our
      subsidiaries. We are also not involved in any material legal proceedings, except
      as described below.





In
      July
      2003, a former Liraz shareholder filed an application with the Tel Aviv, Jaffa
      District Court to approve a claim filed by him against us, as a class action.
      The claim relates to the acquisition of Liraz shares, which we completed in
      March 2003. The shareholder alleges that the share price we paid to
      Liraz ’ s
      shareholders in the tender offer and in a subsequent mandatory purchase was
      lower than the fair price of Liraz shares. The maximum amount of the claim
      is
      approximately $7.3 million in the aggregate. Under Israeli law, the
      court ’ s
      approval is required for the plaintiff to represent all of the shareholders
      of
      Liraz who sold their shareholdings to us pursuant to the tender offer and the
      mandatory acquisition. The plaintiff has applied for such approval in the
      lawsuit. Based on our analysis of the statement of claim, including an
      evaluation of the fair value of the Liraz shares, and the price paid for Liraz
      in a previous transaction immediately prior to the tender offer, we believe
      that
      the allegations against us in this proceeding are without merit and we intend
      to
      vigorously defend the claim and contest the allegations made therein .





***Dividend
      policy***





We
      have
      never declared or paid dividends to our shareholders and we do not intend to
      pay
      dividends in the future. We anticipate that we will retain all of our future
      earnings for use in the expansion and operation of our business. We are not
      subject to any contractual restrictions on paying dividends. Any future
      determination relating to our dividend policy will be made at the discretion
      of
      our board of directors and will depend on a number of factors, including our
      future earnings, capital requirements, financial condition, future prospects
      and
      other factors as the board of directors may deem relevant. Israeli law limits
      the distribution of cash dividends to the greater of retained earnings or
      earnings generated over the two most recent years, in either case provided
      that
      we reasonably believe that the dividend will not render us unable to meet our
      current or foreseeable obligations when due.




75




**B.**  **Significant
      Changes** ****





Except
      as
      otherwise disclosed in this annual report, there has been no material change
      in
      our financial position since December 31, 2006.




**ITEM
      9. THE OFFER AND LISTING**




**A.**  **Offer
      and Listing Details** ****





The
      following table shows the high and low closing price for our ordinary shares
      on
      the NASDAQ Global Market for the periods indicated.





**Calendar
                Period**
            
            **Price
                Per Share****High**
            
            **Low****(in
                $)****2002**
            
            
            4.15
            
            
            2.00**2003**
            
            
            7.04
            
            
            2.10**2004**
            
            
            7.49
            
            
            3.71**2005**
            
            
            4.75
            
            
            3.81**2006**
            
            
            6.75
            
            
            3.71First
                Quarter
            
            
            5.66
            
            
            3.71Second
                Quarter
            
            
            5.78
            
            
            4.70Third
                Quarter
            
            
            5.87
            
            
            4.41Fourth
                Quarter
            
            
            6.75
            
            
            5.03September
            
            
            5.65
            
            
            5.02October
            
            
            5.90
            
            
            5.03November
            
            
            5.90
            
            
            5.30December
            
            
            6.75
            
            
            5.26**2007**January
            
            
            6.65
            
            
            5.80February
            
            
            7.24
            
            
            5.81March
                (through March 22)
            
            
            7.10
            
            
            6.05





The
      following table shows the high and low closing price for our ordinary shares
      on
      the TASE for the periods indicated.





**Calendar
                Period**
            
            **Price
                Per Share****High**
            
            **Low****(in
                NIS)****2002**
            
            
            20.10
            
            
            8.01**2003**
            
            
            29.20
            
            
            11.49**2004**
            
            
            33.80
            
            
            17.00**2005**
            
            
            21.95
            
            
            16.01First
                Quarter
            
            
            20.99
            
            
            17.80Second
                Quarter
            
            
            19.66
            
            
            16.01Third
                Quarter
            
            
            19.05
            
            
            17.35Fourth
                quarter
            
            
            19.75
            
            
            17.80**2006**
            
            
            25.69
            
            
            18.30First
                Quarter
            
            
            23.99
            
            
            18.30Second
                Quarter
            
            
            24.00
            
            
            23.60Third
                Quarter
            
            
            24.50
            
            
            23.39Fourth
                quarter
            
            
            25.69
            
            
            23.85September
            
            
            23.50
            
            
            23.50October
            
            
            23.85
            
            
            23.85November
            
            
            24.48
            
            
            24.48December
            
            
            25.69
            
            
            25.69**2007**January
            
            
            27.38
            
            
            26.24February
            
            
            28.99
            
            
            28.99March
                (through March 22)
            
            
            28.48
            
            
            28.48




76




The
      following table shows the high and low closing price for our series A
      convertible notes on the TASE for the periods indicated.





**Calendar
                Period**
            
            **Price
                Per note****High**
            
            **Low****(in
                NIS)****2006**(from February 12)
            
            
            1.090
            
            
            1.020First
                quarter (from February 12)
            
            
            1.074
            
            
            1.020Second
                quarter
            
            
            1.090
            
            
            1.073Third
                quarter
            
            
            1.073
            
            
            1.030Fourth
                quarter
            
            
            1.065
            
            
            1.054September
            
            
            1.034
            
            
            1.030October
            
            
            1.025
            
            
            1.025November
            
            
            1.047
            
            
            1.047December
            
            
            1.065
            
            
            1.054**2007**January
            
            
            1.072
            
            
            1.072February
            
            
            1.120
            
            
            1.120March
                (through March 22)
            
            
            1.105
            
            
            1.105




**B.**  **Plan
      of Distribution**





Not
      applicable.




**C.**  **Markets**





Our
      ordinary shares have been traded in the United States on the NASDAQ Global
      Market since our initial public offering on January  30,
      1997
      and were not publicly traded prior to this date. The symbol on the NASDAQ Global
      Market for our ordinary shares is BPHX. On January 21, 2001, we listed our
      ordinary shares for trading on the TASE.





Our
      series A convertible notes have been traded on the TASE since February 12,
      2006.





Pursuant
      to Marketplace Rule 4350(a) of NASDAQ, we received a permanent exemption from
      Marketplace Rule 4350(b)(1)(A), which requires a company to distribute to its
      shareholders copies of its annual report containing its audited financial
      statements. We follow the common practice among TASE companies, and do not
      send
      our annual financial statements to shareholders.  A
      copy of
      our annual report on Form 20-F is posted on our website promptly after it is
      filed with the SEC and the TASE.




77




**D.**  **Selling
      Shareholders**





Not
      applicable.




**E.**  **Dilution**





Not
      applicable.




**F.**  **Expenses
      of the Issue**





Not
      applicable.




**ITEM
      10. ADDITIONAL INFORMATION**




**A.**  **Share
      Capital**





Not
      applicable.




**B.**  **Memorandum
      and Articles of Association**





We
      are
      registered with the Israeli Companies Register under the number 52-004306-8.
      Our
      objects are specified in our memorandum of association. These objects include:





·
            operating
                within the field of informational and computer
                systems;


·
            providing
                management, consulting and sale services for computers, computer
                equipment, software for computers and for information
                systems;


·
            the
                business of systems analysis, systems programming and computer
                programming; and


·
            establishing
                facilities for instruction and training for computers and digital
                systems.





***Description
      of Our Share Capital***





Our
      company share capital consists of ordinary shares. Our articles of association
      do not restrict in any way the ownership of our ordinary shares by nonresidents,
      except that these restrictions may exist with respect to citizens of countries
      that are in a state of war with Israel.





78




***Transfer
      of Shares***





Fully
      paid ordinary shares are issued in registered form and may be freely transferred
      under our articles of association unless the transfer is restricted or
      prohibited by another instrument.





***Modification
      of Class Rights***





Under
      our
      articles of association, the rights attached to any class unless otherwise
      provided by the terms of the class, including voting, rights to dividends and
      the like, may be varied by adoption of the necessary amendment to the articles
      of association, provided that the affected shareholders approve the change
      by a
      class meeting in which a simple majority of the voting power of the class
      represented at the meeting and voting on the matter approves the
      change.





***Dividend
      Rights and Liquidation Rights***





We
      may
      declare a dividend to be paid to the holders of ordinary shares according to
      their rights and interests in our profits. We may pay the dividend as an
      allotment of shares or a distribution of assets. If we do decide to issue
      dividends by an allotment of shares at a price lower than the nominal value
      of
      those shares, we must convert a portion of our profits or any other source
      of
      equity to share capital in an amount equal to the difference between the nominal
      value of the shares and the price paid in the dividend. If dividends remain
      unclaimed for seven years from the date we declared the dividend, they lapse
      and
      revert back to us. In case of liquidation, after satisfying liabilities to
      creditors, our assets will be distributed to the holders of ordinary shares
      in
      proportion to their holdings. This right may be affected by the grant of a
      preferential dividend or distribution rights to the holders of a class of shares
      with preferential rights that may be authorized in the future.





***Redemption
      provisions***





In
      accordance with our articles of association, we may issue redeemable shares
      and
      accordingly redeem those shares. Our board may attach to redeemable shares
      the
      attributes of shares, including voting rights and the right to participate
      in
      profits.





***Voting,
      Shareholder Meetings and Resolutions***





Holders
      of our ordinary shares have one vote for each ordinary share held on all matters
      submitted to the vote of shareholders. These voting rights may be affected
      by
      the grant of any special voting rights to the holders of a class of shares
      with
      preferential rights that may be authorized in the future.





We
      must
      hold an annual general meeting once a year with a maximum period of fifteen
      months between the meetings. All other meetings of shareholders other than
      annual general meetings are considered special general meetings. Our board
      of
      directors may, whenever it decides it is appropriate, and shall, within 21
      days
      after receiving a written demand from one director or from one or more
      shareholders representing at least 10% of the outstanding share capital and
      1%
      of the voting power, call a special general meeting. The quorum required for
      a
      general meeting of shareholders consists of two or more holders present in
      person or by proxy who hold or represent at least 35% of the voting power.
      A
      meeting adjourned for a lack of a quorum generally is adjourned to the same
      day
      in the following week at the same time and place or to another later time if
      such time is specified in the original notice convening the general meeting
      or
      if we give notice to the shareholders of another time at least 72 hours before
      the date fixed for the adjourned meeting. At the reconvened meeting, if a quorum
      is not present within half an hour from the time appointed for holding the
      meeting, the required quorum will consist of two shareholders present in person
      or by proxy.





79




Under
      the
      Companies Law, unless otherwise provided in the articles of association or
      applicable law, all resolutions of the shareholders require a simple majority,
      except in certain circumstances provided for under the Companies Law, which
      require a majority of at least 75% of the shares present at the meeting. In
      accordance with the Companies Law, all shareholders meetings require prior
      notice of at least 21 days. In some instances specified in regulations
      promulgated under the Companies Law, a 35-day prior notice should be given
      of a
      shareholders meeting.





Under
      the
      Companies Law, a shareholder has a duty to act in good faith towards the company
      in which he holds shares and towards other shareholders and to refrain from
      abusing his power in the company including voting in the general meeting of
      shareholders on:





·
            any
                amendment to the articles of
                association;


·
            an
                increase of the company’s authorized share
                capital;


·
            a
                merger; or


·
            approval
                of some of the acts and transactions that require shareholder
                approval.





A
      shareholder has the general duty to refrain from depriving rights of other
      shareholders. Any controlling shareholder, any shareholder who knows that it
      possesses the power to determine the outcome of a shareholder vote and any
      shareholder that, under the provisions of the articles of association, has
      the
      power to appoint an office holder in the company, is under a duty to act in
      fairness towards the company. The Companies Law does not describe the substance
      of this duty.





***Election
      of Directors***





Our
      ordinary shares do not have cumulative voting rights in the election of
      directors. As a result, the holders of ordinary shares that represent more
      than
      50% of the voting power represented at a shareholders meeting have the power
      to
      elect all of our directors, other than the outside directors that are appointed
      by a special majority of shareholders. For a summary of those provisions in
      our
      articles of association with respect to the directors, see “Item 6. Directors,
      Senior Management, and Employees.”





80




***Anti-Takeover
      Provisions; Mergers and Acquisitions under Israeli
      Law***





*Mergers*





The
      Companies Law includes provisions that allow a merger transaction and requires
      that each company that is party to a merger approve the transaction by its
      board
      of directors and a vote of the majority of its shares voting on the proposed
      merger at a shareholders’ meeting called on at least 21 days’ prior notice. In
      determining whether a majority has approved the merger, shares held by the
      other
      party to the merger or any person holding at least 25% of the other party to
      the
      merger are excluded from the vote. The Companies Law does not require court
      approval of a merger other than in specified situations. Upon the request of
      a
      creditor of either party to the proposed merger, the court may delay or prevent
      the merger if it concludes that there exists a reasonable concern that as a
      result of the merger, the surviving company will be unable to satisfy the
      obligations of any of the parties to the merger. In addition, a merger may
      not
      be completed unless at least 70 days have passed from the time that a proposal
      for approval of the merger has been filed with the Israeli registrar of
      companies.





*Tender
      Offers*





The
      Companies Law also provides that an acquisition of shares of a public company
      on
      the open market must be made by means of a tender offer if as a result of the
      acquisition the purchaser would become a 25% shareholder of the company. The
      rule does not apply if there is already another 25% shareholder of the company.
      Similarly, the Companies Law provides that an acquisition of shares in a public
      company must be made by means of a tender offer if, as a result of the
      acquisition, the purchaser would become a 45% shareholder, unless there is
      a 50%
      shareholder of the company. These rules do not apply if the acquisition is
      made
      by way of a merger as opposed to a tender offer. Regulations adopted under
      the
      Companies Law provide that these tender offer requirements do not apply to
      companies whose shares are listed for trading outside of Israel if, according
      to
      the law in the country in which the shares are traded, including the rules
      and
      regulations of the stock exchange on which the shares are traded, there is
      either a limitation on acquisition of any level of control of the company,
      or
      the acquisition of any level of control requires the purchaser to do so by
      means
      of a tender offer to the public. The Companies Law also provides that if
      following any acquisition of shares, the acquirer holds 90% or more of the
      company’s shares or of a class of shares, the acquisition must be made by means
      of a tender offer for all the target company’s shares or all the shares of the
      class, as applicable. An acquirer who wishes to eliminate all minority
      shareholders must do so by way of a tender offer and acquire 95% of all shares
      not held by or for the benefit of the acquirer before the acquisition. If,
      however, the tender offer to acquire 95% is not successful, the acquirer may
      not
      acquire shares tendered if by doing so the acquirer would own more than 90%
      of
      the shares of the target company.




**C.**  **Material
      Contracts**





We
      consider the agreements related to the $5 million private placements of
      convertible debentures and warrants completed in March 2004, the issuance of
      the
      series A convertible notes in
      an
      aggregate principal amount of NIS 54.0 million (that were equal at the time
      of
      issuance to approximately $11.5 million) and the
      purchase agreement with CodeStream, as material contracts. For
      a
      summary of the terms of these transactions, see “ Item
      4.B.
      Business Overview – Investments and Acquisitions ” and “ Item
      5.B.
      Liquidity and Capital Resources. ” In
      addition, the agreement with SDC Udvikling described below is material to our
      business.





81




*Services
      Agreement with SDC Udvikling*





In
      October 2002, we entered into a services agreement with an affiliated company
      of
      SDC, named SDC Udvikling A/S, for the provision of IT development services
      related to our tool, AppBuilder. Under the agreement, SDC Udvikling has been
      purchasing from us various services pursuant to specific amendments to the
      agreement and purchase orders signed from time to time. SDC Udvikling accounted
      for 11% and 17% of our revenues in 2006 and 2005.




**D.**  **Exchange
      Controls**





Under
      current Israeli regulations, we may pay dividends or other distributions in
      respect of our ordinary shares either in non-Israeli or Israeli currencies.
      If
      we make these payments in Israeli currency, they will be freely transferred
      in
      non-Israeli currencies at the rate of exchange prevailing at the time of
      conversion. Because exchange rates between the NIS and the dollar fluctuate
      continuously, a U.S. shareholder will be subject to the risk of currency
      fluctuations between the date when we declare NIS-denominated dividends and
      the
      date when we pay them in NIS. See “Item 3.D. Risk Factors.”





Nonresidents
      of Israel may freely hold and trade our securities pursuant to the general
      permit issued under the Israeli Currency Control Law, 1978. Neither our
      memorandum of association nor the laws of the State of Israel restrict in any
      way the ownership of our ordinary shares by nonresidents, except that these
      restrictions may exist with respect to citizens of countries that are in a
      state
      of war with Israel.




**E.**  **Taxation** ****





***Israeli
      Taxation***





The
      following is a description of material tax consequences regarding the ownership
      and disposition of the Company’s ordinary shares under Israeli tax laws to which
      U.S. and other non-Israeli shareholders may be subject. The information below
      does not apply to specified persons or cover specified situations. Therefore,
      you are advised to consult your own tax advisor as to particular tax
      consequences unique to you related to an investment in our ordinary shares
      including the effects of applicable Israeli or foreign or other tax laws and
      possible changes in the tax laws.


To
      the
      extent that the discussion is based on legislation yet to be judicially or
      administratively interpreted, we cannot assure you that the views we express
      herein will accord with any such interpretation in the future.




82





*Tax
      Consequences Regarding Disposition of Our Ordinary Shares*





In
      general, Israel imposes capital gains tax on the sale of capital assets,
      including shares of Israeli companies by both Israeli residents and non-Israeli
      resident shareholders, unless a specific exemption is available or unless a
      tax
      treaty between Israel and the shareholders’ country of residence provide
      otherwise. Shareholders that are not Israeli residents are generally exempt
      from
      Israeli capital gains tax on any gain derived from the sale of our ordinary
      shares, provided that (i) such shareholders did not acquire the shares
      prior to our initial public offering; and (ii) such gains did not derive
      from a permanent establishment of such shareholders in Israel. However,
      non-Israeli corporations will not be entitled to the foregoing exemption if
      an
      Israeli resident (a) has a controlling interest of 25% or more in such
      non-Israeli corporation; or (b) is the beneficiary of or is entitled to 25%
      or more of the revenues or profits of such non-Israeli corporation, whether
      directly or indirectly.





In
      certain instances where our non-Israeli shareholders may be liable to Israeli
      tax on the sale of our ordinary shares, the payment of the consideration may
      be
      subject to Israeli withholding tax.





In
      addition, in the case when the sale, exchange or disposition of our ordinary
      shares by shareholders who are U.S. residents (within the meaning of the
      U.S.-Israel Tax Treaty) holding the ordinary shares as a capital asset will
      be
      also exempt from Israeli capital gains tax under the U.S.-Israel Tax Treaty,
      unless, either (i) the shareholders hold, directly or indirectly, shares
      representing 10% or more of our voting shares during any part of the 12-month
      period preceding such sale, exchange or disposition; or (ii) the capital
      gains arising from such sale, exchange or disposition are attributable to a
      permanent establishment of the shareholders located in Israel. In such case,
      the
      shareholders would be subject to Israeli capital gain tax, to the extent
      applicable, as mentioned above. However, under the U.S.-Israel Tax Treaty,
      the
      U.S. resident would be permitted to claim a credit for such taxes against
      the U.S. federal income tax imposed on the sale, exchange or disposition,
      subject to the limitation in the U.S. law applicable to foreign tax
      credits. The U.S.-Israel Tax Treaty does not relate to U.S. state or local
      taxes.





*Taxes
      Applicable to Dividends*





Nonresidents
      of Israel are generally subject to Israeli income tax on the receipt of
      dividends paid on our ordinary shares at the rate of 20% or 15% for dividends
      or
      income generated by an approved enterprise, which tax will be withheld at
      source, unless a different rate is provided in a treaty between Israel and
      the
      shareholder’s country of residence.


However,
      the tax rate on dividends paid to a “substantial shareholder” (which is someone
      who alone, or together with another person, holds, directly or indirectly,
      at
      least 10% in one or all of any of the means of control in the corporation)
      is
      25%.





Under
      Israeli tax law, a distribution of dividends from income attributable to an
      Approved Enterprise will be subject to tax in Israel at the rate of 15%, which
      is withheld and paid by the company paying the dividend, if the dividend is
      distributed during the benefits period or within the following 12 years (but
      the
      12-year limitation does not apply to a Foreign Investors Company). Any
      distribution of dividends from income that is not attributable to an Approved
      Enterprise after January 1, 2006, will be subject to tax in Israel at the rate
      of 20%.




83




Under
      the
      U.S.-Israel Tax Treaty, the maximum rate of tax withheld in Israel on dividends
      paid to a holder of our ordinary shares who is a U.S. resident (within the
      meaning of the U.S.-Israel Tax Treaty) is 25%. However, dividends paid from
      income derived from our Approved Enterprise are subject to withholding at the
      rate of 15%, although we cannot assure you that we will designate the profits
      that are being distributed in a way that will reduce shareholders’ tax liability
      according to the U.S.-Israel Tax Treaty. Furthermore, the maximum rate of
      withholding tax on dividends, not generated by our Approved Enterprise, that
      are
      paid to a U.S. corporation holding 10% or more of our outstanding voting
      capital during the part of the tax year that precedes the date of the payment
      of
      the dividend and during the whole of its prior tax year, is 12.5%. This reduced
      rate will not apply if more than 25% of our gross income consists of interest
      or
      dividends, other than dividends or interest received from a subsidiary
      corporation 50% or more of the outstanding shares of the voting shares of which
      are owned by the company.





A
      nonresident of Israel who receives dividends with respect of which tax was
      fully
      paid, is generally exempt from the duty to file returns in Israel in respect
      of
      such income, provided such income was not derived from a business conducted
      in
      Israel by the taxpayer, and the taxpayer has no other taxable sources of income
      in Israel.





***United
      States Federal Income Tax Considerations***





Subject
      to the limitations described herein, this discussion summarizes certain U.S.
      federal income tax consequences of the purchase, ownership and disposition
      of
      our ordinary shares to a U.S. holder. A U.S. holder is a holder of our ordinary
      shares that is:




·
            an
                individual citizen or resident of the U.S. for U.S. federal income
                tax
                purposes;


·
            a
                corporation (or another entity taxable as a corporation for U.S.
                federal
                income tax purposes) created or organized under the laws of the United
                States or any political subdivision
                thereof;


·
            an
                estate, the income of which is subject to U.S. federal income tax
                regardless of its source; or


·
            a
                trust (i) if, in general, a U.S. court is able to exercise primary
                supervision over its administration and one or more U.S. persons
                have the
                authority to control all of its substantial decisions or (ii) that
                has in
                effect a valid election under applicable U.S. Treasury Regulations
                to be
                treated as a U.S. person.





If
      a
      partnership (or any other entity treated as a partnership for U.S. federal
      income tax purposes) holds our ordinary shares, the tax treatment of the
      partnership and a partner in such partnership will depend on the status of
      the
      partner and the activities of the partnership. Such a partner or partnership
      should consult its tax advisor as to its consequences.





Unless  otherwise
      specifically indicated, this discussion does not consider the U.S. federal
      income tax consequences to a person that is not a U.S. holder (a “Non-U.S.
      holder”) and considers only U.S. holders that will own the ordinary shares as
      capital assets (generally, for investment).





84





This
      discussion is based on current provisions of the Internal Revenue Code of 1986,
      as amended, referred to as the Code, current and proposed Treasury Regulations
      promulgated under the Code and administrative and judicial interpretations
      of
      the Code, all as currently in effect and all of which are subject to change,
      possibly with a retroactive effect. This discussion does not address all aspects
      of U.S. federal income taxation that may be relevant to any particular U.S.
      holder based on the U.S. holder’s individual circumstances. In particular, this
      discussion does not address the U.S. federal income tax consequences to U.S.
      holders who are broker-dealers or who own, directly, indirectly or
      constructively, 10% or more of our outstanding voting shares, U.S. holders
      holding the ordinary shares as part of a hedging, straddle or conversion
      transaction, U.S. holders whose functional currency is not the U.S. dollar,
      insurance companies financial service companies, real estate investment trusts,
      regulated investment trusts, grantor trusts, certain former citizens and
      long-term residents of the United States, tax-exempt organizations, financial
      institutions, persons who acquired their ordinary shares upon the exercise
      of
      employee stock options or otherwise as compensation, and persons subject to
      the
      alternative minimum tax, who may be subject to special rules not discussed
      below. Additionally, the possible application of U.S. federal estate or gift
      taxes or any aspect of state, local or non-U.S.  tax
      laws
      to a U.S. holder is not discussed below.





**You
      are advised to consult your tax advisor with respect to the specific U.S.
      federal, state, local, and foreign income and other tax consequences to you
      of
      purchasing, holding, or disposing of our ordinary shares.**





*Taxation
      of Distributions on the Ordinary Shares*





We
      have
      never paid dividends, and currently do not intend to pay dividends in the
      future. If we make distributions in the future, the amount of the distribution
      with respect to the ordinary shares will equal the amount of cash and the fair
      market value of any property distributed and will also include the amount of
      any
      non-U.S. tax withheld, including Israeli taxes withheld as described above
      under
“Taxation – Israeli Taxation.” Subject to the discussion below under “Tax
      Consequences if We are a Passive Foreign Investment Company,” a distribution
      paid by us with respect to our ordinary shares to a U.S. holder will be treated
      as dividend income to the extent that the distribution does not exceed our
      current and accumulated earnings and profits, as determined for U.S. federal
      income tax purposes.  Dividends
      that are received by U.S. holders that are individuals, estates or trusts will
      be taxed at a reduced rate of tax (currently a maximum rate of 15% for taxable
      years beginning on or before December 31, 2010), provided that such dividends
      meet the requirements of “qualified dividend income.” Dividends that fail to
      meet such requirements, and dividends received by corporate U.S. holders, are
      taxed at ordinary income rates. No dividend received by a U.S. holder will
      be a
      qualified dividend (1) if the U.S. holder held the ordinary share with
      respect to which the dividend was paid for less than 61 days during the 121-day
      period beginning on the date that is 60 days before the ex-dividend date with
      respect to such dividend, excluding for this purpose, under the rules of Code
      section 246(c), any period during which the U.S. holder has an option to sell,
      is under a contractual obligation to sell, has made and not closed a short
      sale
      of, is the grantor of a deep-in-the-money or otherwise nonqualified option
      to
      buy, or has otherwise diminished its risk of loss by holding other positions
      with respect to, such ordinary share (or substantially identical securities)
      or
      (2) to the extent that the U.S. holder is under an obligation (pursuant to
      a short sale or otherwise) to make related payments with respect to positions
      in
      property substantially similar or related to the ordinary share with respect
      to
      which the dividend is paid. If we were to be a “passive foreign investment
      company” (as such term is defined in the Code) for any year, dividends paid on
      our ordinary shares in such year or in the following year would not be qualified
      dividends. In addition, a non-corporate U.S. holder will be able to take a
      qualified dividend into account in determining its deductible
      investment  interest
      (which is generally limited to its net investment income) only if it elects
      to
      do so; in such case the dividend will be taxed at ordinary income
      rates.


85





The
      amount of any distribution that exceeds the amount treated as a dividend will
      be
      treated first as a nontaxable return of capital, reducing the U.S. holder’s tax
      basis in its ordinary shares to the extent thereof, and then as capital gain
      from the deemed disposition of the ordinary shares. Corporate holders will
      not
      be allowed a deduction for dividends received in respect of the ordinary
      shares.





Dividends
      paid by us in NIS will be included in the income of U.S. holders at the dollar
      amount of the dividend (including any non-U.S. taxes withheld therefrom) based
      upon the spot rate of exchange in effect on the date the distribution is
      included in income. U.S. holders will have a tax basis in NIS for U.S. federal
      income tax purposes equal to that dollar value. Any subsequent gain or loss
      in
      respect of NIS arising from exchange rate fluctuations generally will be taxable
      as U.S. source ordinary income or loss.





Subject
      to the limitations set forth in the Code and the Treasury Regulations
      thereunder, U.S.  holders
      may elect to claim as a foreign tax credit against their U.S. federal income
      tax
      liability the non-U.S. income tax withheld from dividends received in respect
      of
      the ordinary shares. The limitations on claiming a foreign tax credit include,
      among others, computation rules under which foreign tax credits allowable with
      respect to specific classes of income cannot exceed the U.S. federal income
      taxes otherwise payable with respect to each such class of income. In this
      regard, dividends paid by us generally will be foreign source “passive income”
for U.S. foreign tax credit purposes, U.S. holders that do not elect to claim
      a
      foreign tax credit may instead claim a deduction for the non-U.S. income tax
      withheld if they itemize deductions. The rules relating to foreign tax credits
      are complex, and you should consult your tax advisor to determine whether and
      to
      what extent you would be entitled to this credit. A U.S. holder will be denied
      a
      foreign tax credit for non-U.S. income tax withheld from a dividend received
      on
      the ordinary shares (i) if the U.S. holder has not held the ordinary shares
      for
      at least 16 days of the 31-day period beginning on the date that is 15 days
      before the ex-dividend date with respect to such dividend or (ii) to the extent
      the U.S. holder is under an obligation to make related payments with respect
      to
      positions in substantially similar or related property. Any days during which
      a
      U.S. holder has substantially diminished its risk of loss on the ordinary shares
      are not counted toward meeting the required 16-day holding period.





*Taxation
      on Disposition of the Ordinary Shares*





Subject
      to the discussion below under “Tax Consequences if We are a Passive Foreign
      Investment Company,” upon the sale, exchange or other disposition of our
      ordinary shares, a U.S. holder will recognize capital gain or loss in an amount
      equal to the difference between the amount realized on the disposition and
      the
      U.S. holder’s tax basis in the ordinary shares. The gain or loss recognized on
      the disposition will be long-term capital gain or loss if the U.S. holder held
      the ordinary shares for more than one year at the time of the disposition.
      Long-term capital gains are subject to a maximum tax of 15% for taxable years
      beginning on or before December 31, 2010. Gain or loss recognized by a U.S.
      holder on a sale, exchange or other disposition of ordinary shares generally
      will be treated as U.S. source income or loss for U.S. foreign tax credit
      purposes.




86





A
      U.S.
      holder that uses the cash method of accounting calculates the dollar value
      of
      the proceeds received on the sale as of the date that the sale settles. However,
      a U.S. holder that uses the accrual method of accounting is required to
      calculate the value of the proceeds of the sale as of the trade date and may
      therefore realize foreign currency gain or loss. A U.S. holder may avoid
      realizing foreign currency gain or loss by electing to use the settlement date
      to determine the proceeds of sale for purposes of calculating the foreign
      currency gain or loss. In addition, a U.S. holder that receives foreign currency
      upon the disposition of ordinary shares and converts the foreign currency into
      dollars after the settlement date or trade date (whichever date the U.S. holder
      is required to use to calculate the value of the proceeds of sale) will have
      foreign exchange gain or loss based on any appreciation or depreciation in
      the
      value of the foreign  currency
      against the dollar, which generally will be U.S. source ordinary income or
      loss.





*Tax
      Consequences If We Are a Passive Foreign Investment Company*





We
      will
      be a passive foreign investment company, or PFIC, for a taxable year if either
      (1) 75% or more of our gross income in the taxable year is passive income or
      (2)
      50% or more of the value, determined on the basis of a quarterly average, of
      our
      assets in the taxable year produce, or are held for the production of, passive
      income. If we own (directly or indirectly) at least 25% by value of the stock
      of
      another  corporation,
      we will be treated for purposes of the foregoing tests as owning our
      proportionate share of the other corporation’s assets and as directly earning
      our proportionate share of the other corporation’s gross income. We believe that
      in 2006 we were not a PFIC and currently we expect that we will not be a PFIC
      in
      2007. However, PFIC status is determined as of the end of the taxable year
      and
      is dependent on a number of factors, including the value of our assets and
      the
      amount and type of our gross income. Therefore, there can be no assurance that
      we will not become a PFIC for the current fiscal year ending December 31, 2007
      or in any future year. We will notify U.S. holders in the event we conclude
      that
      we will be treated as a PFIC for any taxable year.





If
      we are
      a PFIC, a U.S. holder must determine under which of three alternative taxing
      regimes it wishes to be taxed:




•
            The
                “QEF” regime applies if the U.S. holder elects to treat us as a “qualified
                electing fund” (“QEF”) for the first taxable year in which the U.S. holder
                owns our ordinary shares or in which we are a PFIC, whichever is
                later,
                and if we comply with certain reporting requirements. Under current
                law, a
                QEF election cannot be made with respect to warrants or options to
                acquire
                our ordinary shares. If the QEF regime applies, then each year that
                we are
                a PFIC such U.S. holder will include in its gross income a proportionate
                share of our ordinary earnings (which is taxed as ordinary income)
                and net
                capital gain (which is taxed as long-term capital gain), subject
                to a
                separate election to defer payment of taxes, which deferral is subject
                to
                an interest charge. These amounts would be included in income by
                an
                electing U.S. holder for its taxable year in which our taxable year
                ends,
                whether or not such amounts are actually distributed to the U.S.
                holder. A
                U.S. holder’s basis in our ordinary shares for which a QEF election has
                been made would be increased to reflect the amount of any taxed but
                undistributed income. Generally, a QEF election allows an electing
                U.S.
                holder to treat any gain realized on the disposition of his ordinary
                shares as capital gain.





87





Once
      made, the QEF election applies to all subsequent taxable years of the U.S.
      holder in which it holds our ordinary shares and for which we are a PFIC, and
      can be revoked only with the consent of the United States Internal Revenue
      Service (“IRS”). The QEF election is made by attaching a completed IRS Form
      8621, including the PFIC annual information statement, to a timely filed United
      States federal income tax return. Even if a QEF election is not made, a U.S.
      holder who is a shareholder in a PFIC must file a completed IRS Form 8621 every
      year. If we believe we are or will become a PFIC, we will determine whether
      we
      will comply with the reporting requirements that would enable holders to make
      a
      QEF election. If a QEF election is made after the first taxable year in which
      a
      U.S. holder holds our ordinary shares and we are a PFIC, then special rules
      would apply.





•
            A
                second regime, the “mark-to-market” regime, may be elected so long as our
                ordinary shares are “marketable stock” (e.g. “regularly traded” on the
                Nasdaq Global Market). Pursuant to this regime, an electing U.S.
                holder’s
                ordinary shares are marked-to-market each year that we are a PFIC
                and the
                U.S. holder recognizes as ordinary income or loss an amount equal
                to the
                difference as of the close of the taxable year between the fair market
                value of our ordinary shares and the U.S. holder’s adjusted tax basis
                therein. Losses are allowed only to the extent of net mark-to-market
                gain
                previously included by the U.S. holder under the election for prior
                taxable years. An electing U.S. holder’s adjusted basis in our ordinary
                shares is increased by income recognized under the mark-to-market
                election
                and decreased by the deductions allowed under the
                election.





Under
      the
      mark-to-market election, gain on the sale of our ordinary shares is treated
      as
      ordinary income, and loss on the sale of our ordinary shares, to the extent
      the
      amount of loss does not exceed the net mark-to-market gain previously included,
      is treated as ordinary loss. Under current law, a mark-to-market election cannot
      be made with respect to warrants or options to acquire our ordinary shares.
      The
      mark-to-market election applies to the tax year for which the election is made
      and all subsequent tax years, unless the ordinary shares cease to be marketable
      stock or the IRS consents to the revocation of the election.





If
      the
      mark-to-market election is made after the first taxable year in which a U.S.
      holder holds our ordinary shares and we are a PFIC, then special rules would
      apply.





•
            A
                U.S. holder making neither the QEF election nor the mark-to-market
                election is subject to the “excess distribution” regime. Under this
                regime, “excess distributions” are subject to special tax rules. An excess
                distribution is either (1) a distribution with respect to ordinary
                shares
                that is greater than 125% of the average distributions received by
                the
                U.S. holder from us over the shorter of either the preceding three
                years
                or such U.S. holder’s holding period for our ordinary shares or (2) 100%
                of the gain from the disposition of our ordinary shares (including
                gain
                deemed recognized if the ordinary shares are used as security for
                a
                loan).





88


Excess
      distributions must be allocated ratably to each day that a U.S. holder has
      held
      our ordinary shares. A U.S. holder must include amounts allocated to the current
      taxable year and to any period prior to the first day of the first taxable
      year
      for which we are a PFIC in its gross income as ordinary income for the current
      taxable year. All amounts allocated to other years of the U.S. holder would
      be
      taxed at the highest tax rate for each such other year applicable to ordinary
      income. The U.S. holder also would be liable for interest on the deferred tax
      liability for each such other year calculated as if such liability had been
      due
      with respect to each such other year. The portions of distributions that are
      not
      characterized as “excess distributions” are subject to tax in the current year
      under the normal tax rules of the Code.





A
      U.S.
      person who inherits shares in a foreign corporation that was a PFIC in the
      hands
      of the decedent is denied the otherwise available step-up in the tax basis
      of
      such shares to fair market value at the date of death.





**The
      PFIC rules described above are complex. U.S. holders are urged to consult their
      tax advisors regarding the application of the PFIC rules, including eligibility
      for and the manner and advisability of making, the QEF election or the
      mark-to-market election.**





*Non-U.S.
      holders of Ordinary Shares*





Except
      as
      provided below, a Non-U.S. holder of ordinary shares will not be subject to
      U.S.
      federal income or withholding tax on the receipt of dividends on, and the
      proceeds from the disposition of, an ordinary share, unless that item is
      effectively connected with the conduct by the Non-U.S. holder of a trade or
      business in the United States and, in the case of a resident of a country that
      has an income tax treaty with the United States, that item is attributable
      to a
      permanent establishment in the United States or, in the case of an individual,
      a
      fixed place of business in the United States. In addition, gain recognized
      by an
      individual Non-U.S. holder will be subject to tax in the United States if the
      Non-U.S. holder is present in the United States for 183 days or more in the
      taxable year of the sale and other conditions are met.





*Information
      Reporting and Backup Withholding*





A
      U.S.
      holder generally is subject to information reporting and may be subject to
      backup withholding at a rate of up to 28% with respect to dividend payments
      on,
      and the proceeds from the disposition of, the ordinary shares. Backup
      withholding will not apply with respect to payments made to exempt recipients,
      including corporations, or if a U.S. holder provides correct taxpayer
      identification number (or certifies that he has applied for a taxpayer
      identification number), certifies that such holder is not subject to backup
      withholding or otherwise establishes an exemption. Backup withholding is not
      an
      additional tax and may be claimed as a credit against the U.S. federal income
      tax liability of a U.S. holder, or alternatively, the U.S. holder may be
      eligible for a refund of any excess amounts withheld under the backup
      withholding rules, in either case, provided that the required information is
      furnished to the IRS.





Non-U.S.
      holders will generally not be subject to information reporting or backup
      withholding with respect to the payment of dividends on, and the proceeds from
      the disposition of, ordinary shares provided that the Non-U.S. holder provides
      its taxpayer identification number, certifies to its foreign status, or
      otherwise establishes an exemption.




89




**F.**  **Dividend
      and Paying Agents**





Not
      applicable.




**G.**  **Statement
      by Experts**





Not
      applicable.




**H.**  **Documents
      on Display**





BluePhoenix
      is subject
      to the reporting requirements of the Exchange Act of 1934, as amended, that
      are
      applicable to a foreign private issuer. In accordance with the Exchange Act,
      we
      file with the SEC reports, including annual reports on Form 20-F by June 30
      each
      year. In addition, we file interim financial information on Form 6-K on a
      quarterly basis. We also furnish to the SEC under cover of Form 6-K certain
      other material information required to be made public in Israel, filed with
      and
      made public by any stock exchange or distributed by us to our
      shareholders. You may
      inspect without charge and copy at prescribed rates such material at the public
      reference facilities maintained by the SEC, 100 F Street, N.E., Washington,
      D.C.
      20549. You may also obtain copies of such material from the SEC at prescribed
      rates by writing to the Public Reference Section of the SEC, 100 F Street,
      N.E.,
      Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for further
      information on the public reference room.





The
      SEC
      maintains an Internet site at http://www.sec.gov that
      contains reports and other material that are filed through the SEC’s Electronic
      Data Gathering, Analysis and Retrieval (“EDGAR”) system. BluePhoenix began
      filing through the EDGAR system beginning on November 14, 2002.





BluePhoenix’s
      ordinary shares are quoted on the NASDAQ Global Market. You may inspect reports
      and other information concerning BluePhoenix at the offices of the National
      Association of Securities Dealers, Inc., 9513 Key West Avenue, Rockville,
      Maryland 20850. You may also find our reports filed with the ISA on the Magna
      site whose address is http://www.magna.isa.gov.il.


Our
      Internet address is http://www.bphx.com .
      A copy
      of each report submitted in accordance with applicable United States law is
      available for public review at our principal executive offices.




**I.**  **Subsidiary
      Information**





Not
      applicable.




90




**ITEM
      11. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET** **RISK** ****




In
      light
      of the nature of our activities, we invest our cash and cash equivalents, in
      short-term time deposits. As of December 31, 2006, we invested substantially
      all
      of the cash we held in NIS, dollars, euro and DKK currency accounts. In
      addition, we had outstanding loans in dollars and euro. Fluctuations in foreign
      currency exchange rates, such as euro or NIS versus the dollar may have a
      negative impact on our operating results and financial condition. Accordingly,
      the interest rates that we pay may also have a major impact on our financial
      expenses. Our interest expenses are most sensitive to the changes in the London
      Interbank Offered Rate (LIBOR) since most of our borrowings are linked to the
      LIBOR. As of December 31, 2006, we had approximately $38.6 million in
      outstanding loans, debentures and notes linked to the LIBOR. Depending upon
      the
      circumstances, we enter from time to time into currency and interest options
      and
      forward transactions to decrease the risk of financial exposure from
      fluctuations in the exchange rate of the dollar versus any other applicable
      foreign currencies, and the changes in the LIBOR. As of December 31, 2006,
      we
      were obligated to purchase 5 million euro at an average exchange rate of 1.285
      euro per one dollar and to sell 8 million euro at an average exchange rate
      of
      1.2948 euro per dollar. As of December 31, 2006, we entered into LIBOR interest
      forward transactions for $10.8 million at an average interest rate of
      5.08%.





The
      table
      below presents information regarding our borrowings and their expected maturity
      dates:





**As
                at December 31, 2006****Expected
                Maturity date****2008**
            
            **2009**
            
            **2010**
            
            **2011**
            
            **2012****Liabilities**(US$
                equivalent in millions)Long
                term debt:Variable
                rate (US$**)**
            
            
            10,784
            
            
            6,368
            
            
            7,153
            
            
            7,153
            
            
            2,278Average
                interest rate
            
            
            6.18%
            
            
            6.86%
            
            
            6.64%
            
            
            5.18%
            
            
            5.88%Interest
                rate derivativesInterest
                rate swapsVariable
                to fixed (US$)
            
            
            10,750Average
                pay rate
            
            
            6.58%




**ITEM
      12. DESCRIPTION OF SECURITIES OTHER THAN EQUITY SECURITIES**





Not
      applicable.


91


**P
      A R T II**





**ITEM
      13. DEFAULTS, DIVIDEND ARREARAGES AND DELINQUENCIES**





Not
      applicable.




**ITEM
      14. MATERIAL MODIFICATIONS TO THE RIGHTS OF SECURITY HOLDERS AND USE OF
      PROCEEDS**





Not
      applicable.




**ITEM
      15. CONTROLS AND PROCEDURES**





(a) *Disclosure
      Controls and Procedures.* Our
      chief
      executive officer and chief financial officer, after evaluating the
      effectiveness of our disclosure controls and procedures (as defined in Rule
      13a-15(e) of the Securities Exchange Act of 1934, as amended) as of
      December 31, 2006, have concluded that, as of such date, our disclosure
      controls and procedures were effective to ensure that information required
      to be
      disclosed by us in reports that we file or submit under the Exchange Act is
      accumulated and communicated to our management, including our chief executive
      officer and chief financial officer, to allow timely decisions regarding
      required disclosure and is recorded, processed, summarized and reported within
      the periods specified by the SEC’s rules and forms.




(b) *Internal
      Controls.* Since
      the
      date of the evaluation described above, there have been no significant changes
      in our internal controls over financial reporting or in other factors that
      have
      materially affected, or are reasonably likely to materially affect, our internal
      control over financial reporting.




**ITEM
      16A. AUDIT COMMITTEE FINANCIAL EXPERT**





Our
      board
      of directors has determined that Mr. Michael Chill and Ms. Amira Berkovitz-Amir,
      both members of our audit committee, are "audit committee financial experts"
      and
      are independent as defined by applicable SEC regulations.


92


**ITEM
      16B. CODE OF ETHICS**





BluePhoenix
      has adopted a code of business conduct and ethics applicable to its executive
      officers, directors and all other employees. A copy of the code is available
      without charge to all BluePhoenix’s employees, investors and others upon request
      to the following address: BluePhoenix Solutions Ltd. 8 Maskit St. Herzliya
      46120, Israel, Attn: Legal Advisor. Any waiver of this code for executive
      officers or directors will be disclosed through the filing of a Form
      6-K.




**ITEM
      16C. PRINCIPAL ACCOUNTANT FEES AND SERVICES** ****





***Policy
      of Preapproval of Audit and Non-Audit Services of Independent
      Auditors***





Our
      audit
      committee is responsible for the oversight of our independent auditor’s work.
      The audit committee’s policy is to pre-approve all audit and non-audit services
      provided by Ziv Haft independent registered public accounting BDO member firm.
      These services may include audit services, audit-related services, tax services
      and other services, as further described below. The audit committee sets forth
      the basis for its pre-approval in detail, listing the particular services or
      categories of services that are pre-approved, and setting forth a specific
      budget for such services. Additional services may be pre-approved by the audit
      committee on an individual basis. Once services have been pre-approved, Ziv
      Haft
      independent registered public accountant BDO member firm and our management
      then
      report to the audit committee on a periodic basis regarding the extent of
      services actually provided in accordance with the applicable pre-approval,
      and
      regarding the fees for the services performed. ****





***Principal
      Accountant Fees and Services***





BluePhoenix
      paid the following fees for professional services rendered by Ziv Haft
      independent registered certified public accountants (Isr.) and other BDO member
      firm, for the years ended December 31, 2005 and 2006:





**2006**
            
            **2005**($
                in thousands)Audit
                Fees
            
            $
            302
            
            $
            266Audit-Related
                Fees
            
            
            -
            
            
            -Tax
                Fees
            
            
            46
            
            
            73All
                Other Fees
            
            
            13
            
            
            -**Total**
            
            $
            361
            
            $
            339





The
      audit
      fees for the years ended December 31, 2006 and 2005 were for professional
      services rendered for the audits of our annual consolidated financial
      statements, statutory audits of BluePhoenix and its subsidiaries, issuance
      of
      comfort letters, consents and assistance with review of documents filed with
      the
      SEC.





Audit-related
      fees are fees for assurance and related services by the independent auditor
      that
      are reasonably related to the performance of the audit or review of the
      company’s financial statements that are not disclosed under “Audit Fees.” We had
      no “Audit-Related Fees” in 2006 or 2005.


93





Tax
      fees
      for the years ended December 31, 2006 and 2005 were for services related to
      tax
      compliance, including the preparation of tax returns and claims for refund,
      and
      tax planning and tax advice, including assistance with tax audits and appeals,
      tax services for employee benefit plans and assistance with respect to requests
      for rulings from tax authorities.





Other
      fees for the year ended December 31, 2006 were for due diligence related to
      the
      acquisition of CodeStream.




**ITEM
      16D. EXEMPTIONS FROM THE LISTING STANDARDS FOR AUDIT
      COMMITTEES**





Not
      applicable.




**ITEM
      16E. PURCHASES OF EQUITY SECURITIES BY THE ISSUER AND AFFILIATED
      PURCHASERS**





Not
      applicable.




**P
      A R T III**





**ITEM
      17. FINANCIAL STATEMENTS**




We
      have
      responded to Item 18 in lieu of this item.




**ITEM
      18. FINANCIAL STATEMENTS**





The
      financial statements required by this item are found at the end of this annual
      report, beginning on page F-1.









94
 
  ITEM
        19.
        EXHIBITS****
   EXHIBIT
        INDEX


**Exhibit
                No.****1.1**
            
            English
                translation of the Memorandum of Association as amended on July 23,
                2003(1)**1.2**
            
            Articles
                of Association as amended on December 27,
                2005(2)


**4.1**
            
            Agreement
                dated January 11, 2001 among the Registrant, the Israel Mezzanine
                Fund
                L.P., The Israel Mezzanine Fund, The Jordan (Bermuda) Investment
                Company
                Ltd.(3)******4.2**
            
            Amendment
                dated August 7, 2003 to agreement among the Registrant, the Israel
                Mezzanine Fund L.P., The Israel Mezzanine Fund and The Jordan (Bermuda)
                Investment Company Ltd. dated January 11, 2001(4)******4.3**
            
            Share
                Purchase Agreement dated March 30, 2004, among the Registrant and
                four
                institutional investors in connection with a $5 million private
                placement(5)**4.4**
            
            Amendment
                dated February 18, 2005 to Share Purchase Agreement among the Registrant
                and four institutional investors in connection with a $5 million
                private
                placement(5)**4.5**
            
            Registration
                Rights Agreement dated March 30, 2004, among the Registrant and four
                institutional investors in connection with a $5 million private
                placement(5)**4.6**
            
            The
                1996 Share Option Plan – Part One, as amended on January 28, 1997,
                December 5, 1999, December 18, 2000, December 26, 2000 and August
                6,
                2003(4)**4.7**
            
            Agreement
                dated January 1, 1996 between the Registrant and Argotec
                Ltd.(6)**4.8**
            
            English
                translation of Loan Agreement between Liraz Systems Ltd. and Arie
                Kilman
                dated April 2000 as amended by the Addendum dated April
                2002(4)**4.9**
            
            Form
                of Indemnification Letter dated December 27, 2005 between the Registrant
                and certain office holders(2)**4.10**
            
            Summary
                of credit line Letter Agreement between the Registrant and Bank Leumi
                Le’Israel Ltd.(4)**4.11**
            
            Master
                Services Agreement between BluePhoenix Solutions Nordic AS and SDC
                Udvikling A/S dated October 1, 2002(2)**4.12**
            
            Agreement
                dated December 14, 2006 among the registrant, CodeStream Software
                Ltd. and
                certain shareholders of CodeStream Software Ltd.**4.13**
            
            English
                translation of cooperation agreement dated August 8, 2006 between
                Matrix
                IT Ltd. and the Registrant**8**
            
            List
                of Subsidiaries**12.1**
            
            Certification
                of the Chief Executive Officer pursuant to §302 of the Sarbanes-Oxley
                Act





95





**Exhibit
                No.****12.2**
            
            Certification
                of the Chief Financial Officer pursuant to §302 of the Sarbanes-Oxley
                Act**13.1**
            
            Certification
                of the Chief Executive Officer pursuant to 18 U.S.C. §1350, as adopted
                pursuant to §906 of the Sarbanes-Oxley Act**13.2**
            
            Certification
                of the Chief Financial Officer pursuant to 18 U.S.C. §1350, as adopted
                pursuant to §906 of the Sarbanes-Oxley Act**15**
            
            Consent
                of Ziv Haft registered certified public accountants (Isr.) BDO member
                firm





(1) Incorporated by reference to the Registration Statement on Form F-1 filed with
      the Securities and Exchange Commission on December 24, 1996.




(2) Incorporated by reference to the Registrant annual report on Form 20-F filed
      with the Securities and Exchange Commission on March 27, 2006.




(3) Incorporated by reference to the Registrant annual report on Form 20-F filed
      with the Securities and Exchange Commission on June 29, 2001.




(4) Incorporated by reference to the Registrant annual report on Form 20-F filed
      with the Securities and Exchange Commission on June 1, 2004, as amended on
      November 9, 2004.




(5) Incorporated by reference to the Registration Statement on Form F-3 filed with
      the Securities and Exchange Commission on June 1, 2004, as amended on November
      9, 2004 and on February 18, 2005.




(6) Incorporated by reference to Amendment No. 1 to the Registration Statement
      on
      Form F-1 filed with the Securities and Exchange Commission on January 28,
      1997.


96




SIGNATURES





The
      registrant hereby certifies that it meets all of the requirements for filing
      on
      Form 20-F and that it has duly caused and authorized the undersigned to sign
      this annual report on its behalf.





BLUEPHOENIX
                  SOLUTIONS LTD.(Registrant)By:
              /s/
                  Varda SagivVarda
                  Sagiv
                Chief
                  Financial Officer





Date:
        December 26, 2007





**EXHIBIT
      INDEX**





**Exhibit
                No.****1.1**
            
            English
                translation of the Memorandum of Association as amended on July 23,
                2003(1)**1.2**
            
            Articles
                of Association as amended on December 27,
                2005(2)**4.1**
            
            Agreement
                dated January 11, 2001 among the Registrant, the Israel Mezzanine
                Fund
                L.P., The Israel Mezzanine Fund, The Jordan (Bermuda) Investment
                Company
                Ltd.(3)******4.2**
            
            Amendment
                dated August 7, 2003 to agreement among the Registrant, the Israel
                Mezzanine Fund L.P., The Israel Mezzanine Fund and The Jordan (Bermuda)
                Investment Company Ltd. dated January 11, 2001(4)******4.3**
            
            Share
                Purchase Agreement dated March 30, 2004, among the Registrant and
                four
                institutional investors in connection with a $5 million private
                placement(5)**4.4**
            
            Amendment
                dated February 18, 2005 to Share Purchase Agreement among the Registrant
                and four institutional investors in connection with a $5 million
                private
                placement(5)**4.5**
            
            Registration
                Rights Agreement dated March 30, 2004, among the Registrant and four
                institutional investors in connection with a $5 million private
                placement(5)**4.6**
            
            The
                1996 Share Option Plan – Part One, as amended on January 28, 1997,
                December 5, 1999, December 18, 2000, December 26, 2000 and August
                6,
                2003(4)**4.7**
            
            Agreement
                dated January 1, 1996 between the Registrant and Argotec
                Ltd.(6)**4.8**
            
            English
                translation of Loan Agreement between Liraz Systems Ltd. and Arie
                Kilman
                dated April 2000 as amended by the Addendum dated April
                2002(4)**4.9**
            
            Form
                of Indemnification Letter dated December 27, 2005 between the Registrant
                and certain office holders(2)**4.10**
            
            Summary
                of credit line Letter Agreement between the Registrant and Bank Leumi
                Le’Israel Ltd.(4)**4.11**
            
            Master
                Services Agreement between BluePhoenix Solutions Nordic AS and SDC
                Udvikling A/S dated October 1, 2002(2)**4.12**
            
            Agreement
                dated December 14, 2006 among the registrant, CodeStream Software
                Ltd. and
                certain shareholders of CodeStream Software Ltd.








**Exhibit
                No.****4.13**
            
            English
                translation of cooperation agreement dated August 8, 2006 between
                Matrix
                IT Ltd. and the Registrant**8**
            
            List
                of Subsidiaries**12.1**
            
            Certification
                of the Chief Executive Officer pursuant to §302 of the Sarbanes-Oxley
                Act**12.2**
            
            Certification
                of the Chief Financial Officer pursuant to §302 of the Sarbanes-Oxley
                Act**13.1**
            
            Certification
                of the Chief Executive Officer pursuant to 18 U.S.C. §1350, as adopted
                pursuant to §906 of the Sarbanes-Oxley Act**13.2**
            
            Certification
                of the Chief Financial Officer pursuant to 18 U.S.C. §1350, as adopted
                pursuant to §906 of the Sarbanes-Oxley Act**15**
            
            Consent
                of Ziv Haft registered certified public accountants (Isr.) BDO member
                firm







(1) Incorporated by reference to the Registration Statement on Form F-1 filed with
      the Securities and Exchange Commission on December 24, 1996.




(2) Incorporated by reference to the Registrant annual report on Form 20-F filed
      with the Securities and Exchange Commission on March 27, 2006.




(3) Incorporated by reference to the Registrant annual report on Form 20-F filed
      with the Securities and Exchange Commission on June 29, 2001.




(4) Incorporated by reference to the Registrant annual report on Form 20-F filed
      with the Securities and Exchange Commission on June 1, 2004, as amended on
      November 9, 2004.




(5) Incorporated by reference to the Registration Statement on Form F-3 filed with
      the Securities and Exchange Commission on June 1, 2004, as amended on November
      9, 2004 and on February 18, 2005.




(6) Incorporated by reference to Amendment No. 1 to the Registration Statement
      on
      Form F-1 filed with the Securities and Exchange Commission on January 28,
      1997.







**BLUEPHOENIX
      SOLUTIONS LTD.**


**2006
      Annual Report**









**BLUEPHOENIX
      SOLUTIONS LTD.**


**2006
      CONSOLIDATED FINANCIAL STATEMENTS**





**TABLE
      OF CONTENTS**





**Page****Report
                of Independent Registered Public Accounting Firm**
            F-1**Consolidated
                Financial Statements:**Balance
                Sheets
            F-2Statements
                of Operations
            F-3Statements
                of Changes in Shareholders’ Equity
            F-4Statements
                of Cash Flows
            F-5 –
                F-6Notes
                to Consolidated Financial Statements
            F-7 –
                F-57




**The
      amounts are stated in U.S. dollars ($).**










**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**


**To
      the Shareholders and Board of Directors of**


**BLUEPHOENIX
      SOLUTIONS LTD.**








We
      have
      audited the accompanying consolidated balance sheets of BluePhoenix Solutions
      Ltd. (the “Company”) and its subsidiaries as of December 31, 2006 and 2005 and
      the related consolidated statements of operations, changes in shareholders’
equity and cash flows for each of the three years in the period ended December
      31, 2006. These financial statements are the responsibility of the Company’s
      management. Our responsibility is to express an opinion on these financial
      statements based on our audits.





We
      conducted our audits in accordance with the standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audit to obtain reasonable assurance about whether the financial
      statements are free of material misstatement. The company is not required to
      have, nor were we engaged to perform, an audit of its internal control over
      financial reporting. Our audits included consideration of internal control
      over
      financial reporting as a basis for designing audit procedures that are
      appropriate in the circumstances, but not for the purpose of expressing an
      opinion on the effectiveness of the Company’s internal control over financial
      reporting. Accordingly, we express no such opinion. An audit also includes
      examining, on a test basis, evidence supporting the amounts and disclosures
      in
      the financial statements, assessing the accounting principles used and
      significant estimates made by management, as well as evaluating the overall
      financial statement presentation. We believe that our audits provide a
      reasonable basis for our opinion.





In
      our
      opinion, the consolidated financial statements referred to above present fairly,
      in all material respects, the consolidated financial position of the Company
      and
      its subsidiaries as of December 31, 2006 and 2005, and the related consolidated
      results of its operations and cash flows for each of the three years in the
      period ended December 31, 2006, in conformity with accounting principles
      generally accepted in the United States of America.





As
      discussed in Note 2J to the consolidated financial statements, the Company
      changed the manner in which it accounts for share-based compensation effective
      January 1, 2006 to conform with FASB Statement of Financial Accounting
      Standards No. 123 (revised 2004), “Share-Based Payment”.




Tel
      Aviv,
      Israel


March
      29,
      2007





Ziv
      Haft


Certified
      Public Accountants (Isr.)


BDO
      Member Firm




F-1


**BLUEPHOENIX
        SOLUTIONS LTD.**


**CONSOLIDATED
      BALANCE SHEETS**




**December 31,****2006**
            
            **2005****(in thousands)****ASSETS****CURRENT
                ASSETS (Note 12):**Cash
                and cash equivalents
            
            $
            11,627
            
            $
            10,791Marketable
                securities
            
            
            1,053
            
            
            -Trade
                accounts receivable (Note 14A1)
            
            
            26,489
            
            
            18,143Other
                current assets (Note 14A2)
            
            
            3,096
            
            
            2,495Total
                current assets
            
            
            42,265
            
            
            31,429**LONG-TERM
                TRADE RECIVABLES**
            
            
            1,390
            
            
            -**INVESTMENTS
                IN AFFILIATES AND OTHER COMPANIES**
            
            
            -
            
            
            370**PROPERTY
                AND EQUIPMENT, NET (Note 3)**
            
            
            2,147
            
            
            2,160**GOODWILL
                (Note 4)**
            
            
            44,838
            
            
            38,832**SOFTWARE
                DEVELOPMENT COSTS AND OTHER (Note 5)******
            
            
            36,826
            
            
            26,900**Total
                assets**
            
            $
            127,466
            
            $
            99,691**LIABILITIES
                AND SHAREHOLDERS’ EQUITY****CURRENT
                LIABILITIES (Note 12):**Short-term
                bank credit and others (Note 6)
            
            $
            609
            
            $
            14,095Convertible
                debentures
            
            
            4,482
            
            
            -Accounts
                payable and accruals:Trade
            
            
            4,594
            
            
            3,088Deferred
                revenue
            
            
            7,790
            
            
            2,776Other
                (Note 14A3)
            
            
            6,929
            
            
            6,924Total
                current liabilities
            
            
            24,404
            
            
            26,883**LONG-TERM
                LIABILITIES:**Convertible
                debentures (Note 11B2, 11B3)
            
            
            14,049
            
            
            4,342Accrued
                severance pay, net (Note 7)
            
            
            1,718
            
            
            1,309Provision
                for losses in formerly-consolidated subsidiary (Note 8)
            
            
            1,971
            
            
            1,971Loans
                from banks and others (Note 9)
            
            
            20,027
            
            
            8,389Total
                long-term liabilities
            
            
            37,765
            
            
            16,011**MINORITY
                INTERESTS**
            
            
            5,348
            
            
            5,031**COMMITMENTS
                AND CONTINGENCIES (Note 10)****SHAREHOLDERS’
                EQUITY (Note 11):**Share
                capital - ordinary shares of NIS 0.01 par value (authorized: December
                31, 2006 and 2005 - 30,000,000 shares; issued: December 31, 2006
                15,945,952 shares; December 31, 2005 - 15,430,403 shares)
            
            
            31
            
            
            31Additional
                paid-in capital
            
            
            58,556
            
            
            56,205Accumulated
                other comprehensive loss
            
            
            (1,537
            )
            
            (1,537
            )Retained
                earnings
            
            
            16,447
            
            
            11,77573,497
            
            
            66,474Cost
                of 1,647,594 Company shares held by subsidiaries (December 31,2005
                -
                1,870,565 shares)
            
            
            (13,548
            )
            
            (14,708
            )Total
                shareholders’ equity
            
            
            59,949
            
            
            51,766**Total
                liabilities and shareholders’ equity**
            
            $
            127,466
            
            $
            99,691





F-2




**BLUEPHOENIX
      SOLUTIONS LTD.**


**CONSOLIDATED
      STATEMENTS OF OPERATIONS**





**Year ended December 31,****2006**
            
            **2005**
            
            **2004****(in thousands, except per share data)**Revenues
                (Note 14B1):Products
            
            $
            10,150
            
            $
            8,718
            
            $
            11,525Services
            
            
            57,854
            
            
            50,229
            
            
            45,661Total
                revenues
            
            
            68,004
            
            
            58,947
            
            
            57,186Cost
                of revenues:Products
            
            
            1,882
            
            
            1,570
            
            
            969Services
            
            
            26,633
            
            
            23,809
            
            
            23,284Total
                cost of revenues
            
            
            28,515
            
            
            25,379
            
            
            24,253Gross
                profit
            
            
            39,489
            
            
            33,568
            
            
            32,933Software
                development costs, net
            
            
            9,400
            
            
            8,006
            
            
            8,055Selling,
                general, and administrative expenses
            
            
            22,149
            
            
            21,611
            
            
            21,388Operating
                income
            
            
            7,940
            
            
            3,951
            
            
            3,490Financial
                expenses, net (Note 14B3)
            
            
            (3,515
            )
            
            (1,978
            )
            
            (882
            )Gain
                on realization of shareholdings (Note 14B4)
            
            
            -
            
            
            -
            
            
            112Other
                income, net (Note 14B5)
            
            
            282
            
            
            104
            
            
            975Income
                before taxes on income
            
            
            4,707
            
            
            2,077
            
            
            3,695Taxes
                on income (benefit) (Note 13)
            
            
            (282
            )
            
            149
            
            
            2604,989
            
            
            1,928
            
            
            3,435Share
                in losses of affiliated companies, net
            
            
            -
            
            
            -
            
            
            (516
            )Minority
                interest in profits of subsidiaries
            
            
            (317
            )
            
            (139
            )
            
            (73
            )Net
                income
            
            $
            4,672
            
            $
            1,789
            
            $
            2,846**Earnings
                per share (Note 14C):**Basic
            
            $
            0.34
            
            $
            0.13
            
            $
            0.21Diluted
            
            $
            0.33
            
            $
            0.13
            
            $
            0.21**Weighted
                average number of shares outstanding (Note 14C):**Basic
            
            
            13,889
            
            
            13,557
            
            
            13,523Diluted
            
            
            14,371
            
            
            13,960
            
            
            14,679




**The
      accompanying notes are an integral part of the consolidated financial
      statements.**





F-3




**BLUEPHOENIX
        SOLUTIONS LTD.**


**CONSOLIDATED
      STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY**


**Share
                  capital****Number of**
                **shares**
              
              **Par****value**
              
              **Additional**
                **paid-in**
                **capital**
              
              **Accumulated**
                **other**
                **comprehensive**
                **loss**
              
              **Retained**
                **earnings**
              
              **Cost of**
                **Company**
                **shares held by**
                **subsidiaries**
              
              **Total****(in
                  thousands, except shares)****Balance
                  at December 31, 2003**
              
              
              13,484,276
              
              
              $30
              
              
              $54,412
              
              
              $(1,476
              )
              
              $7,140
              
              
              $(14,708
              )
              $
              45,398**Changes
                  during 2004:**Components
                  of comprehensive income:Net
                  income
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              2,846
              
              
              -
              
              
              2,846Currency
                  translation adjustments
              
              
              -
              
              
              -
              
              
              -
              
              
              (155
              )
              
              -
              
              
              -
              
              
              (155
              )Total
                  comprehensive income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              2,691Issuance
                  of shares
              
              
              31,496
              
              
              1
              
              
              199
              
              
              -
              
              
              -
              
              
              -
              
              
              200Issuance
                  of options
              
              
              -
              
              
              -
              
              
              48
              
              
              -
              
              
              -
              
              
              -
              
              
              48Beneficial
                  conversion features
              
              
              -
              
              
              -
              
              
              173
              
              
              -
              
              
              -
              
              
              -
              
              
              173Exercise
                  of employee share options
              
              
              33,767
              
              
              *-
              
              
              121
              
              
              -
              
              
              -
              
              
              -
              
              
              121**Balance
                  at December 31, 2004**
              
              
              13,549,539
              
              
              31
              
              
              54,953
              
              
              (1,631
              )
              
              9,986
              
              
              (14,708
              )
              
              48,631**Changes
                  during 2005:**Components
                  of comprehensive income:Net
                  income
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              1,789
              
              
              -
              
              
              1,789Currency
                  translation adjustments
              
              
              -
              
              
              -
              
              
              -
              
              
              94
              
              
              -
              
              
              -
              
              
              94Total
                  comprehensive income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              1,883Issuance
                  of options
              
              
              -
              
              
              -
              
              
              48
              
              
              -
              
              
              -
              
              
              -
              
              
              48Change
                  in fair value of a conversion feature upon modification
              
              
              -
              
              
              -
              
              
              325
              
              
              -
              
              
              -
              
              
              -
              
              
              325Classification
                  of warrants to equity
              
              
              -
              
              
              -
              
              
              848
              
              
              -
              
              
              -
              
              
              -
              
              
              848Exercise
                  of employee share options
              
              
              10,299
              
              
              *-
              
              
              31
              
              
              -
              
              
              -
              
              
              -
              
              
              31**Balance
                  at December 31, 2005**
              
              
              13,559,838
              
              
              31
              
              
              56,205
              
              
              (1,537
              )
              
              11,775
              
              
              (14,708
              )
              
              51,766**Changes
                  during 2006:**Components
                  of comprehensive income:Net
                  income
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              4,672
              
              
              -
              
              
              4,672Currency
                  translation adjustments
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Total
                  comprehensive income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              4,672Issuance
                  of options
              
              
              -
              
              
              -
              
              
              48
              
              
              -
              
              
              -
              
              
              -
              
              
              48Stock-based
                  compensation
              
              
              -
              
              
              -
              
              
              40
              
              
              -
              
              
              -
              
              
              -
              
              
              40Conversion
                  of convertible debentures
              
              
              257,133
              
              
              *
              
              
              1,164
              
              
              -
              
              
              -
              
              
              -
              
              
              1,164Sale
                  of shares held by a subsidiary
              
              
              136,000
              
              
              *
              
              
              42
              
              
              -
              
              
              -
              
              
              492
              
              
              534Issuance
                  of shares in respect of acquisition of activity (Note 2D)
              
              
              138,591
              
              
              *
              
              
              (37
              )
              
              -
              
              
              -
              
              
              668
              
              
              631Classification
                  of warrants to equity
              
              
              -
              
              
              -
              
              
              364
              
              
              -
              
              
              -
              
              
              -
              
              
              364Exercise
                  of employee share options
              
              
              206,796
              
              
              *
              
              
              730
              
              
              -
              
              
              -
              
              
              -
              
              
              730**Balance
                  at December 31, 2006**
              
              
              14,298,358
              
              $
              31
              
              $
              58,556
              
              $
              (1,537
              )
              $
              16,447
              
              $
              (13,548
              )
              $
              59,949


*****  **Less
        than $1 thousand.**


**The
      accompanying notes are an integral part of the consolidated financial
      statements.**





F-4




**BLUEPHOENIX
        SOLUTIONS LTD.**
 **CONSOLIDATED
        STATEMENTS OF CASH FLOWS**


**Year ended December 31,****2006**
            
            **2005**
            
            **2004****(in thousands)****CASH
                FLOWS FROM OPERATING ACTIVITIES:**Net
                income
            
            $
            4,672
            
            $
            1,789
            
            $
            2,846Adjustments
                to reconcile net income to net cash provided by operating
                activities:Minority
                interests in profits of subsidiaries
            
            
            317
            
            
            139
            
            
            73Share
                in losses of affiliated companies, net
            
            
            -
            
            
            -
            
            
            516Depreciation
                and amortization
            
            
            8,481
            
            
            7,001
            
            
            4,430Increase
                (decrease) in accrued severance pay, net
            
            
            409
            
            
            (343
            )
            
            (362
            )Loss
                (gain) on sale of property and equipment
            
            
            (32
            )
            
            (35
            )
            
            14Gain
                on realization of shareholdings and expiration of options
            
            
            -
            
            
            -
            
            
            (112
            )Change
                in value of long term-loans and liabilities
            
            
            1,853
            
            
            410
            
            
            275Stock –
                based compensation
            
            
            40
            
            
            -
            
            
            -Deferred
                income taxes, net
            
            
            13
            
            
            58
            
            
            (104
            )Changes
                in operating assets and liabilities:Increase
                (decrease) in marketable securities
            
            
            (715
            )
            
            177
            
            
            600Increase
                in trade receivables
            
            
            (9,731
            )
            
            (1,221
            )
            
            (2,011
            )Decrease
                (increase) in other current assets
            
            
            (909
            )
            
            544
            
            
            (335
            )Increase
                (decrease) in trade payables
            
            
            1,390
            
            
            (1,939
            )
            
            437Increase
                (decrease) in other accounts payable
            
            
            4,186
            
            
            (1,388
            )
            
            (5,138
            )Net
                cash provided by operating activities
            
            
            9,974
            
            
            5,192
            
            
            1,129**CASH
                FLOWS FROM INVESTING ACTIVITIES:**Purchase
                of property and equipment
            
            
            (676
            )
            
            (700
            )
            
            (1,118
            )Proceeds
                from sale of property and equipment
            
            
            161
            
            
            277
            
            
            203Investment
                and loans to affiliated and other companies
            
            
            -
            
            
            (370
            )
            
            (97
            )Repayment
                of loan
            
            
            -
            
            
            -
            
            
            68Proceeds
                from sale of investments
            
            
            -
            
            
            -
            
            
            2,777Capitalization
                of software development and other costs
            
            
            (8,259
            )
            
            (8,117
            )
            
            (7,117
            )Purchase
                of minority interest in subsidiaries and purchase of
                activity
            
            
            (1,118
            )
            
            (180
            )
            
            -Investment
                in newly-consolidated subsidiaries and purchase of newly-activity
                (Appendix A)
            
            
            (13,224
            )
            
            (1,343
            )
            
            (95
            )Net
                cash used in investing activities
            
            
            (23,116
            )
            
            (10,433
            )
            
            (5,379
            )**CASH
                FLOWS FROM FINANCING ACTIVITIES:**Short-term
                bank credit, net
            
            
            (14,013
            )
            
            153
            
            
            (2,350
            )Repayment
                of long-term loans
            
            
            (1,149
            )
            
            (542
            )
            
            (2,063
            )Receipt
                of long-term loans
            
            
            14,391
            
            
            7,003
            
            
            2,443Issuance
                of convertible debentures and warrants
            
            
            14,140
            
            
            -
            
            
            5,000Debentures
                issuance costs
            
            
            (655
            )
            
            -
            
            
            (643
            )Exercise
                of employee share options
            
            
            730
            
            
            31
            
            
            121Sale
                of shares held by a subsidiary
            
            
            534
            
            
            -
            
            
            -Net
                cash provided by financing activities
            
            
            13,978
            
            
            6,645
            
            
            2,508**EFFECT
                OF FOREIGN EXCHANGE RATE CHANGES ON CASH**
            
            
            -
            
            
            24
            
            
            -NET
                INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
            
            
            836
            
            
            1,428
            
            
            (1,742
            )CASH
                AND CASH EQUIVALENTS AT BEGINNING OF YEAR
            
            
            10,791
            
            
            9,363
            
            
            11,105CASH
                AND CASH EQUIVALENTS AT END OF YEAR
            
            $
            11,627
            
            $
            10,791
            
            $
            9,363




**The
      accompanying notes are an integral part of the consolidated financial
      statements.**




F-5




**BLUEPHOENIX
        SOLUTIONS LTD.**
 **CONSOLIDATED
        STATEMENTS OF CASH FLOWS**


**Year ended December 31,****2006**
            
            **2005**
            
            **2004****(in thousands)****SUPPLEMENTAL
                DISCLOSURE OF CASH FLOW**
              **INFORMATION:**Cash
                paid during the year for:Income
                taxes
            
            $
            239
            
            $
            1,221
            
            $
            1,316Interest
            
            $
            1,473
            
            $
            864
            
            $
            443




**APPENDIX
      A - INVESTMENT IN NEWLY-CONSOLIDATED SUBSIDIARIES AND PURCHASE OF
      ACTIVITY:**




**Year ended December 31,****2006**
            
            **2005**
            
            **2004****(in thousands)**Working
                capital, other than cash
            
            $
            1,486
            
            $
            105
            
            $
            2,631Investment
                and loans to affiliated Company
            
            
            370
            
            
            -
            
            
            27Property
                and equipment
            
            
            (289
            )
            
            (100
            )
            
            (373
            )Minority
                interests
            
            
            -
            
            
            -
            
            
            98Customer
                related intangible assets and other
            
            
            -
            
            
            (564
            )
            
            (425
            )Goodwill
            
            
            (5,778
            )
            
            -
            
            
            (283
            )Capitalized
                software development costs
            
            
            (8,077
            )
            
            (1,158
            )
            
            (6,056
            )Customer
                relations intangible asset
            
            
            (470
            )
            
            -
            
            
            -Non-current
                liabilities
            
            
            (466
            )
            
            374
            
            
            4,086Company
                shares issued upon acquisition
            
            
            -
            
            
            -
            
            
            200Net
                cash used in acquisition
            
            $
            (13,224
            )
            $
            (1,343
            )
            $
            (95
            )




**APPENDIX
      B - NON-CASH ACTIVITIES:**




**Year ended December 31,****2006**
            
            **2005**
            
            **2004****(in thousands)**Investment
                in subsidiaries
            
            $
            275
            
            $
            1,577
            
            $
            -Purchase
                of minority interest in subsidiaries
            
            $
            -
            
            $
            100
            
            $
            -Conversion
                of convertible debentures
            
            $
            1,164
            
            $
            -
            
            $
            -




**The
      accompanying notes are an integral part of the consolidated financial
      statements.**





F-6


**BLUEPHOENIX
      SOLUTIONS LTD.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**Note
      1 - Summary of Significant Accounting Policies:**




**A.**
            **General:**




The
      significant accounting policies, applied on a consistent basis, are as
      follows:




1.
            The
                Company:




BluePhoenix
      Solutions Ltd. (“BluePhoenix”) (together with its subsidiaries, the “Company”)
      is an Israeli corporation, which operates in one reportable operating business
      segment enterprise IT modernization solutions. The Company develops and markets
      software tools and provides consulting services for efficient modernization
      of
      legacy systems and cross-platform migration. The Company manages its business
      in
      various international markets through several entities, including its
      wholly-owned subsidiaries located in: USA, UK, Denmark, Germany, Italy,
      Netherlands, Cyprus, Romania, and Israel. Listed below are details relating
      to
      BluePhoenix’s major subsidiaries:




**Shareholding percentage**
            
            **State of**
              **incorporation****Name**
            
            **2006**
            
            **2005****%****Subsidiaries:**BluePhoenix
                Solutions B.V. *
            
            
            100
            
            
            100
            
            
            NetherlandsBluePhoenix
                Solutions Nordic Aps *
            
            
            100
            
            
            100
            
            
            DenmarkBluePhoenix
                Solutions UK Ltd.
            
            
            100
            
            
            100
            
            
            United
                KingdomAdvanced
                Systems Europe B.V. *
            
            
            100
            
            
            100
            
            
            NetherlandsLiraz
                Systems Ltd. (“Liraz”)
            
            
            100
            
            
            100
            
            
            IsraelMainsoft
                Corporation (“Mainsoft”)
            
            
            58
            
            
            58
            
            
            USAOutlook
                & BluePhoenix Ltd.
            
            
            100
            
            
            100
            
            
            IsraelLiacom
                Ltd.
            
            
            51
            
            
            51
            
            
            IsraelI-Ter/Informatica
                & Territorio S.p.A.
            
            
            100
            
            
            100
            
            
            Italy





*
      Indirectly through Liraz





2.
            Principal
                Shareholder:


Formula
      Systems (1985) Ltd. (“Formula”) owns 56% of the Company’s shares as of December
      31, 2006.





3.
            Accounting
                Principles:


The
      consolidated financial statements are prepared in accordance with accounting  principles
      generally accepted (“GAAP”) in the United States of America.





F-8


**BLUEPHOENIX
      SOLUTIONS LTD.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**Note
      1 – Summary
      of Significant Accounting Policies (cont.):**




**A.**
            **General
                (cont.):**




4.
            Functional
                Currency:




The
      currency of the primary economic environment in which the operations of the
      Company and most of its subsidiaries are conducted is the U.S. dollar
      (“dollar”). In addition, a substantial portion of the Company’s revenues and
      costs are incurred in dollars. Thus, the functional and reporting currency
      of
      the Company is considered to be the dollar.





Non
      monetary transactions denominated in currencies other than the dollar are
      measured and recorded in dollar at the exchange rates prevailing at transaction
      date. Monetary assets and liabilities denominated in currencies other than
      the
      dollar are translated at the exchange rate on the balance sheet date. Exchange
      gain or losses on foreign currency translation are recorded in
      income.




For
      consolidated companies whose functional currency is other than the dollar,
      transactions and balances have been translated to dollars under the principles
      prescribed in Statement of Financial Accounting Standards (“SFAS”) No. 52 of the
      Financial Accounting Standards Board (“FASB”). Assets and liabilities have been
      translated at period-end exchange rates. Results of operations have been
      translated at appropriately weighted average exchange rates. Differences
      resulting from such translation are presented as a separate component of
      shareholder’s equity under the caption “Accumulated other comprehensive
      income.”





5.
            Use
                of Estimates and Assumptions in the Preparation of the Financial
                Statements:




The
      preparation of financial statements in conformity with generally accepted
      accounting principles requires management to make estimates and assumptions
      that
      affect the reported amounts of assets and liabilities, disclosure of contingent
      assets and liabilities at the dates of the financial statements and the reported
      amounts of revenues and expenses during the reporting periods. Actual results
      could differ from those estimates.




F-9




**BLUEPHOENIX
      SOLUTIONS LTD.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**Note
      1 - Summary of Significant Accounting Policies (cont.):**




**B.**
            **Principles
                of Consolidation:**




The
      consolidated financial statements include the accounts of BluePhoenix and its
      subsidiaries in which it has a controlling interest, and a certain variable
      interest entity that the Company is required to consolidate pursuant to
      Financial Accounting Standards Board Interpretation No. 46 “Consolidation of
      Variable Interest Entities” as revised in December 2003 (“FIN 46R”) - See also
      Note 2F. Acquisition of subsidiaries is accounted for under the purchase method.
      All intercompany balances and transactions have been eliminated upon
      consolidation.





**C.**
            **Cash
                and Cash Equivalents:**




Cash
      equivalents are considered by the Company to be highly-liquid investments,
      including, inter alia, short-term deposits with banks, the maturity of which
      did
      not exceed three months at the time of deposit and which are not
      restricted.





**D.**
            **Provision
                for Doubtful Accounts:**




The
      provision for doubtful accounts was based on specific receivables the collection
      of which, in the opinion of Company’s management, is in doubt. Trade receivables
      are charged off in the period in which they are deemed to be
      uncollectible.





**E.**
            **Investments:**




Investments
      in affiliates over which the Company exercises significant influence are
      accounted for under the equity method. Investments in other companies are
      accounted for under the cost method. Investments in marketable securities are
      classified as “trading,” and unrealized gains or losses there from are reported
      in the statement of operations in accordance with the principles set forth
      in
      SFAS No. 115 “Accounting for Certain Investments in Debt and Equity Securities.”
Investments are periodically reviewed to determine whether an
      other-than-temporary impairment in value has occurred.




F-10


**BLUEPHOENIX
      SOLUTIONS LTD.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**Note
      1 - Summary of Significant Accounting Policies (cont.):**




**F.**
            **Property
                and Equipment, Net:**




Property
      and equipment are stated at cost, net of accumulated depreciation. Depreciation
      is calculated by the straight-line method over their estimated useful lives.
      Annual rates of depreciation are as follows:




**%**Computers
                and peripheral equipment
            
            20-33
                (mainly 33)Office
                furniture and equipment
            
            6-15
                (mainly 7)Leasehold
                improvements
            
            Over
                the term of the lease or the life of the assets, whichever is
                shorterMotor
                vehicles
            
            15





**G.**
            **Impairment
                of Long-Lived Assets:**





The
      Company’s long-lived assets are reviewed for impairment in accordance with SFAS
      No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets”
whenever events or changes in circumstances indicate that the carrying amount
      of
      an asset may not be recoverable. Recoverability of assets to be held and used
      is
      measured by a comparison of the carrying amount of an asset to the future
      undiscounted cash flows expected to be generated by the assets. If such assets
      are considered to be impaired, the impairment to be recognized is measured
      by
      the amount by which the carrying amount of the assets exceeds their fair value.
      During the years ended December 31, 2006, 2005 and 2004, no impairment losses
      have been identified.





**H.**
            **Goodwill
                and other purchased intangible assets**:




In
      July
      2001, the FASB issued SFAS No. 142, “Goodwill and Other Intangible Assets”
(“SFAS No. 142”). SFAS No. 142 requires goodwill to be tested for impairment on
      an annual basis and between annual tests in certain circumstances, and written
      down when impaired, rather than being amortized as previous accounting standards
      required. Furthermore, SFAS No. 142 requires purchased intangible assets other
      than goodwill to be amortized over their useful lives unless these lives are
      determined to be indefinite.




SFAS
      No.
      142 is effective for fiscal years beginning after December 15, 2001. The Company
      adopted SFAS No. 142 effective January 1, 2002. In accordance with SFAS No.
      142, the Company ceased amortizing goodwill totaling $15.1 million as of the
      beginning of 2002. Based on the impairment tests performed during 2004, 2005,
      and 2006, no impairments losses have been identified. There can be no assurance
      that future goodwill impairment tests will not result in a charge to
      earnings.




F-11




**BLUEPHOENIX
      SOLUTIONS LTD.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**Note
      1 - Summary of Significant Accounting Policies (cont.):**




**I.**
            **Software
                Development Costs:**




Development
      costs of software and products enhancement that are intended for sale, and
      which
      were incurred after the establishment of technological feasibility of the
      relevant product, are  capitalized.  Technological
      feasibility is determined when detailed program design is completed and verified
      in accordance with the provisions of SFAS No. 86 “Accounting for the Cost of
      Computers Software to Be Sold, Leased or Otherwise Marketed.” Software
      development costs incurred before technological feasibility is established
      are
      charged to the statement of operations as incurred, net of participation of
      the
      Office of the Chief Scientist of the Israeli Ministry of Industry and Trade
      (the
“OCS”).





Amortization
      of capitalized software development costs begins when the product is available
      for general release to customers. Annual amortization is computed by the
      straight-line method, over the remaining useful life of the product, or based
      on
      the ratio of current gross revenues to current and anticipated future gross
      revenues, whichever is higher. Currently, capitalized software development
      costs
      are amortized over a period of 5 years. During the year ended December 31,
      2006,
      the Company capitalized software development costs aggregating $7.5 million
      (in
      2005: $8.0 million, and in 2004: $7.1 million) and amortized software
      development costs aggregating $7.1 million (in 2005: $5.1 million, and in 2004:
      $3.1 million) included in cost of revenues.





In
      the
      Company's management estimate, total capitalized costs do not exceed the net
      realizable value of the software product. In the event that unamortized software
      development costs exceed the net realizable value of the product, they would
      be
      written down to net realizable value.





**J.**
            **Employee
                Share Options:**




Effective
      January 1, 2006, the Company adopted the provisions of Statement of
      Financial Accounting Standard No. 123 (revised 2004) (“FAS 123R”),
“Share-Based Payment,” and Staff Accounting Bulletin No. 107 (“SAB 107”),
      which was issued in March 2005 by the SEC. FAS 123R addresses the accounting
      for
      share-based payment transactions in which the Company obtains employee services
      in exchange for equity instruments of the Company. This statement requires
      that
      employee equity awards be accounted for using the grant-date fair value method.
      SAB 107 provides supplemental implementation guidance on FAS 123R, including
      guidance on valuation methods, classification of compensation expense, income
      statement effects, disclosures and other issues.




F-12


**BLUEPHOENIX
      SOLUTIONS LTD.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**




**Note
      1 - Summary of Significant Accounting Policies (cont.):**




**J.**
            **Employee
                Share Options (cont.):**




FAS
      123R
      supersedes the Company’s previous accounting for its employee stock option plans
      using the intrinsic value-based method of accounting prescribed under Accounting
      Principles Board Opinion No. 25 (“APB 25”) and related
      interpretations. The Company elected to adopt the modified prospective
      transition method permitted by FAS 123R. Under such transition method, the
      new
      standard has been implemented as from January 1, 2006, with no restatement
      of prior periods to reflect the fair value method of expensing share-based
      compensation.




The
      Company has expensed compensation costs, applying the accelerated vesting
      method, based on the grant-date fair value estimated in accordance with the
      original provisions of FAS 123, and previously presented in the pro forma
      footnote disclosures. Results for prior periods have not been restated as
      explained above. For the year ended December 31, 2006, the Company recorded
      stock-based compensation costs in the amount of $40 thousand. On
      December 31, 2006, the total unrecognized compensation cost on employee
      stock options amounted to $150 thousand, and is expected to be recognized over
      a
      weighted average period of 3 years.




The
      Company issues stock options to its employees and directors and provides the
      right to purchase stock pursuant to approved stock option and employee stock
      purchase programs. Prior to the adoption of FAS 123R, the Company elected to
      follow Accounting Principles Board Opinion No. 25, “Accounting for Stock Options
      Issued to Employees” and related interpretations (collectively “APB No. 25”), in
      accounting for its stock option plans. Under APB No. 25, when the exercise
      price
      of an employee stock option is less than the market price of the underlying
      stock on the date of grant, compensation expense is recognized. No stock-based
      employee compensation cost was recognized in income for the years ended December
      31, 2004 or 2005, as all options granted under those plans had an exercise
      price
      equal to the market value of the underlying common stock on the date of the
      grant.




As
      a
      result of adopting FAS 123R on January 1, 2006, the Company’s income before
      taxes and net income for the year ended December 31, 2006 was $40 thousand
      lower
      than if the Company had continued to account for share-based compensation under
      APB 25. Basic and diluted earnings per share, compared to reported basic and
      diluted earning per share, for the year ended December 31, 2006 would have
      remained the same if the Company had not adopted FAS 123R.




The
      Company did not realize any tax benefit as a result of the exercise of stock
      options in 2006 prior to the adoption of FAS 123R.





F-13


**BLUEPHOENIX
      SOLUTIONS LTD.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**Note
      1 - Summary of Significant Accounting Policies (cont.):**




**J.**
            **Employee
                Share Options (cont.):**




The
      following table illustrates the effect on net income and earnings per share,
      assuming the Company had applied the fair value recognition provisions of FAS
      123 (as amended by FAS 148) to its stock-based employee
      compensation in prior years:




**Year ended December 31,****2005**
            
            **2004****(in thousands,**
              **except per share data)**Net
                income as reported
            
            $
            1,789
            
            $
            2,846Deduct:
                Total stock-based employee compensation expensedetermined
                under fair value based method for all awards, net ofrelated
                tax effects
            
            
            *(1,851
            )
            
            (624
            )Pro
                forma net income
            
            $
            (62
            )
            $
            2,222Earnings
                per share:Basic
                - as reported
            
            $
            0.13
            
            $
            0.21Basic
                - pro forma
            
            $
            (0.00
            )
            $
            0.16Diluted
                - as reported
            
            $
            0.13
            
            $
            0.21Diluted
                - pro forma
            
            $
            (0.00
            )
            $
            0.16




*  Mainly
      due to an acceleration of unvested stock options (see also Note
      11B1).




**K.**
            **Revenue
                Recognition:**




Revenues
      derived from direct software license agreements are recognized in accordance
      with Statement of Position (SOP) 97-2 “Software Revenue Recognition” (as amended
      by SOP 98-4 and SOP 98-9), upon delivery of the software, when collection is
      probable, the license fee is otherwise fixed or determinable and persuasive
      evidence of an arrangement exists.




The
      arrangements that include multiple elements are usually arrangements where
      the
      Company sells software products and Post Contract Support (PCS).




In
      addition, there are certain arrangements where the Company sells software and
      consulting services.




Consulting
      service fees are based on time invested.




F-14


**BLUEPHOENIX
      SOLUTIONS LTD.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**Note
      1 - Summary of Significant Accounting Policies (cont.):**




**K.**
            **Revenue
                Recognition (cont.):**




For
      these
      multiple elements, SOP 97-2 requires that the fair value of each component
      in a
      multiple element arrangement will be determined based on the vendor’s specific
      objective evidence (VSOE) for that element, and revenue is allocated to each
      component based on its fair value. SOP 98-9 requires  that
      revenue be recognized under the “residual method” when VSOE does not exist for
      all the delivered elements, VSOE of fair value exists for all undelivered
      elements, and all other SOP 97-2 criteria are met. Under the residual method,
      any discount in the arrangement is allocated to the delivered elements. The
      specific objective evidence for the PCS is established by the price charged
      on
      PCS sold separately or renewed. . The VSOE for the consulting services is
      established by the price charged on other time based consulting service
      contracts where no sale of other elements is involved, considering the territory
      where the service is performed, the size of the customer, the quantity of the
      purchased services, the professional expertise of the consultants, etc. The
      revenue associated with the delivered elements is recognized using the residual
      method discussed above.




The
      Company recognizes revenues from consulting fees with respect to projects billed
      on a time and material basis, based on the number of hours
      performed.




In
      some
      of the agreements with the Company’s customers, the customers have the right to
      receive unspecified upgrades on an if-and-when available basis (the Company
      does
      not provide specific upgrades). These upgrades are considered Post-Contract
      Support (PCS). Revenue allocated to the PCS is recognized ratably over the
      term
      of the PCS.





When
      a
      project involves significant production, modification, or customization of
      software, and for other fixed fee contracts, revenue is generally recognized
      according to the percentage of completion method, in accordance with the
      provisions of SOP 81-1 “Accounting for Performance of Construction-Type
      Contracts.” Under this method, estimated revenue is generally accrued based on
      costs incurred to date, as a percentage of total updated estimated costs.
      Contracts with extended payment terms are initially recorded in present value
      in
      accordance with APB 21 "Interest on Receivables and Payables".





The
      Company recognizes contract losses, if any, in the period in which they first
      become evident.




Some
      of
      the Company’s contracts include client acceptance clauses. In these contracts,
      the Company follows the guidance of TPA 5100.67 and SAB 104. In determining
      whether revenue can be recognized, when an acceptance clause exists, the Company
      considers its history with similar arrangements, the customer’s involvement in
      the progress, and the existence of other service providers and the payments
      terms. There are no rights of return, price protection or similar contingencies
      in the Company’s contracts.




On
      December 31, 2006 approximately $13.7 million (on December 31, 2005: $7.8
      million) of the accounts receivable balance was unbilled due to the customers
      payment terms.





F-15




**BLUEPHOENIX
      SOLUTIONS LTD.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**Note
      1 – Summary
      of Significant Accounting Policies (cont.):**




**K.**
            **Revenue
                Recognition (cont.):**




Management
      believes that the Company’s revenue recognition policies are in accordance with
      the Securities and Exchange Commission Staff Accounting Bulletin No. 101
      and SAB 104, “Revenue Recognition in Financial Statements.”




Tax
      collected from customers and remitted to governmental authorities (including
      VAT) are presented in income statement on a net basis.





**L.**
            **Advertising
                Costs:**




The
      Company expenses advertising costs as incurred. Advertising costs for the years
      ended December 31, 2006, 2005, and 2004 were $125, $39, and $25 thousand,
      respectively.





**M.**
            **Gain
                on Realization of
                Shareholdings:**




Gain
      on
      realization of shareholdings includes the results of realization of the
      Company’s shareholdings in investees arising either from the sale of such
      shareholdings or from issuance of stock by the investees to third parties,
      which
      is recognized in accordance with the provisions of Staff Accounting Bulletin
      (SAB) No. 51 of the Securities and Exchange Commission. The Company includes
      such results in statement of operations, provided that the conditions stipulated
      in SAB 51 for such recognition have been met.





**N.**
            **Deferred
                Income Taxes:**




The
      Company accounts for income taxes in accordance with Statement of Financial
      Accounting Standards No. 109, “Accounting for Income Taxes” (“SFAS No. 109”).
      This Statement prescribes the use of the liability method, whereby deferred
      tax
      asset and liability account balances are determined based on differences between
      financial reporting and the tax bases of assets and liabilities and are measured
      using the enacted tax rates and laws that will be in effect when the differences
      are expected to reverse. The Company provides a valuation allowance, when it’s
      more likely than not that deferred tax assets will not be realized in the
      foreseeable future.





**O.**
            **Earnings
                Per Share:**




Earnings
      per share (“EPS”) were computed in accordance with the provisions of SFAS No.
      128 of the FASB (“SFAS No. 128”). SFAS No. 128 requires the presentation of both
      basic and diluted EPS.




Basic
      net
      earnings per share are computed based on the weighted average number of ordinary
      shares outstanding during each year. Diluted earnings per share is computed
      based on the weighted average number of ordinary shares outstanding during
      each
      year, plus dilutive potential ordinary shares considered outstanding during
      the
      year.




F-16


**BLUEPHOENIX
      SOLUTIONS LTD.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**Note
      1 – Summary
      of Significant Accounting Policies (cont.):**




**P.**
            **Financial
                Instruments:**




1.
            Management
                of credit risks:




Financial
      instruments that have the potential to expose the Company to credit risks are
      mainly cash and cash equivalents, marketable securities, bank deposit accounts,
      credit facilities, trade payables, and trade receivables.




The
      Company holds cash and cash equivalents, marketable securities, and deposit
      accounts at large banks in Israel, the United States, and Europe, thereby
      substantially reducing the risk of loss.




With
      respect to trade receivables, the risk is limited due to the nature and size
      of
      the entities that constitute the Company’s customer base. The Company assesses
      the financial position of its customers prior to the engagement with them,
      and
      has not encountered material credit difficulties therewith.





2.
            Fair
                value of financial instruments:




The
      financial instruments of the Company consist mainly of cash and cash
      equivalents, marketable securities, bank deposit accounts, credit facilities,
      trade payables, loans and credit from banks and trade receivables.




The
      convertible debentures are valued using the discounted cash flows model based
      on
      the LIBOR interest rate. Embedded derivatives in connection with the convertible
      debentures are measured at fair value using the Black-Scholes pricing
      model.




The
      Market value of Series A convertible notes is $13.5million as of December 31,
      2006. The book value as of that date was $12.2 million.




In
      view
      of their nature, the fair value of the financial instruments included in the
      Company’s working capital is usually identical or close to their carrying
      value.




**Q.**
            **Comprehensive
                Income:**




The
      Company adopted Statement of Financial Accounting Standards No.130, “Reporting
      Comprehensive Income” (“SFAS 130”). SFAS 130 establishes standards for reporting
      and presentation of comprehensive income and its components in a full set of
      general purpose financial statements.




Comprehensive
      income presented in shareholders’ equity includes, in addition to net income,
      translation gains and losses of non-dollar currency financial statements of
      subsidiaries.




The
      comprehensive income for the years ended December 31, 2004, 2005 and 2006 were
      $2,691, $1,883 and $4,672 thousand, respectively.




F-17


**BLUEPHOENIX
      SOLUTIONS LTD.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**Note
      1 – Summary of Significant Accounting Policies (cont.):**




**R.**
            **Derivative
                Instruments:**




The
      Company has adopted Statement of Financial Accounting Standards SFAS No. 133
      “Accounting for Derivative Instruments and Hedging Activities.” Under the
      provisions of SFAS 133, all derivatives are recognized on the balance sheet
      at
      their fair value. Changes in fair value are recognized periodically in earnings
      or accumulated other comprehensive income within shareholders’ equity, depending
      on the intended use of the derivative and whether the derivative has been
      designated by management as a hedging instrument. Changes in fair value of
      derivative instruments not designated as hedging instruments are recognized
      in
      earnings in the current period.




The
      Company uses foreign currency options, forward exchange contracts and forward
      interest contracts to assist in managing financial risks. The Company does
      not
      use derivative financial instruments for speculative purposes. These instruments
      are recognized at fair value, with all changes in fair value recorded in current
      period earnings, as these transactions have not been designated by management
      as
      hedging instruments under SFAS 133. The net gain recognized in earnings during
      2006, representing the derivative instruments was $275 thousand (in 2005: $200
      thousands). As of December 31, 2006 the Company is obligated to purchase € 5
      million at an average exchange rate of €1.285 per dollar and to sell €8 million
      at an average exchange rate of €1.2948 per dollar).




In
      addition, the Company entered into LIBOR interest forward transaction for $10.8
      million at an average interest rate of 5.08%.





**S.**
            **Royalty-Bearing
                Grants:**




Royalty-bearing
      grants from the Government of Israel and other governmental institutions for
      funding approved research and development projects, are recognized at the time
      the Company is entitled to such grants. Such grants are included as a deduction
      of software development costs. Grants received in 2006, 2005 and 2004 amounted
      to $417, $319 and $398 thousands, respectively. The Company is committed to
      pay
      royalties related to grants from the Government of Israel on sales with regard
      to the funded products of approximately 3% of the generated revenues from such
      products. These royalties are recognized as incurred as costs of
      revenues.





**T.**
            **Treasury
                Shares:**




Treasury
      shares are presented as a reduction of shareholders' equity, at their cost
      to
      the Company.





**U.**
            **Recently
                Issued Accounting
                Pronouncements:**




In
      February 2006, the FASB issued FAS 155, “Accounting for Certain Hybrid Financial
      Instruments, an Amendment of FASB Statements No. 133 and 140”. This
      statement permits fair value measurement for any hybrid financial instrument
      that contains an embedded derivative that otherwise would require bifurcation.
      This statement is effective for all financial instruments acquired or issued
      after the beginning of an entity’s first fiscal year that begins after
      September 15, 2006. The Company is currently evaluating the impact of
      this statement, if any, on its consolidated financial statements.




F-18




**BLUEPHOENIX
      SOLUTIONS LTD.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**Note
      1 – Summary of Significant Accounting Policies (cont.):**




**U.**
            **Recently
                Issued Accounting Pronouncements
                (cont.):**




In
      July
      2006, the FASB issued FIN 48, “Accounting for Uncertainty in Income Taxes-an
      interpretation of FAS 109.” This financial interpretation clarifies the
      accounting for uncertainty in income taxes, and prescribes a recognition
      threshold and measurement attributes for the financial statement recognition
      and
      measurement of a tax position taken or expected to be taken in a tax return.
      FIN
      48 also provides guidance on various related matters such as derecognition,
      interest and penalties and disclosure. As applicable to the Company, the
      interpretation prescribed by FIN 48 will be effective commencing January 1,
      2007. The Company is currently evaluating the impact that the adoption of FIN
      48
      would have on its consolidated financial statements.




In
      September 2006, the FASB issued FAS 157, “Fair Value Measurements”. This
      standard establishes a framework for measuring fair value and expands related
      disclosure requirements; however, it does not require any new fair value
      measurement. As applicable to the Company, this statement will be effective
      as
      of the year beginning January 1, 2008. The Company is currently evaluating
      the impact that the adoption of FAS 157 would have on its consolidated financial
      statements.




In
      September 2006, the SEC issued Staff Accounting Bulletin (SAB) 108, which
      expresses the Staff’s views regarding the process of quantifying financial
      statement misstatements. The bulletin was effective as of the year beginning
      January 1, 2006. The implementation of this bulletin had no impact on the
      Company’s consolidated financial statements.




In
      February 2007, the FASB issued FAS 159, “The Fair Value Option for Financial
      Assets and Financial Liabilities.” This standard permits entities to choose to
      measure many financial assets and financial liabilities at fair value.
      Unrealized gains and losses on items for which the fair value option has been
      elected are reported in earnings. As applicable to the Company, this statement
      will be effective as of the year beginning January 1, 2008. The Company is
      currently evaluating the impact that the adoption of FAS 159 would have on
      its
      consolidated financial statements.




In
      September 2006, the FASB issued SFAS No. 158, "Employers' Accounting for
      Defined Benefit Pension and Other Postretirement Plans—An Amendment of FASB
      No. 87, 88, 106 and 132(R)" ("SFAS 158"). SFAS 158 requires that
      the funded status of defined benefit postretirement plans be recognized on
      the
      company's balance sheet, and changes in the funded status be reflected in
      comprehensive income, effective fiscal years ending after December 15,
      2006. The adoption of this statement did not have an impact on the
      consolidated financial statements.




F-19





**BLUEPHOENIX
      SOLUTIONS LTD.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**Note
      1 – Summary of Significant Accounting Policies (cont.):**




**U.**
            **Recently
                Issued Accounting Pronouncements
                (cont.):**




In
      December 2006, the FASB posted FASB Staff Position, or FSP,
      00-19-2, “Accounting for Registration Payment Arrangements.” This FSP specifies
      that the contingent obligation to make future payments or otherwise transfer
      consideration under a registration payment arrangement, whether issued as a
      separate agreement or included as a provision of a financial instrument or
      other
      agreement should be separately recognized and measured in accordance with FAS
      No. 5, “Accounting for Contingencies.” This FSP further clarifies that a
      financial instrument subject to a registration payment arrangement should be
      accounted for in accordance with other applicable GAAP without regard to the
      contingent obligation to transfer consideration pursuant to the registration
      payment arrangement. This FSP is effective immediately for registration payment
      arrangements and financial instruments subject to those arrangements that were
      entered into or modified subsequent to December 15, 2006. For registration
      payment arrangements and financial instruments subject to those arrangements
      that were entered into prior to December 15, 2006, the FSP is effective for
      fiscal years beginning after December 15, 2006, and interim periods within
      those fiscal years. The company will adopt FSP
      00-19-2 beginning January 1, 2007 and it is currently evaluating the
      potential impact the adoption of this pronouncement will have on its
      consolidated financial statements.




In
      November 2006, the FASB ratified EITF Issue No. 06-7," Issuer’s Accounting for a
      Previously Bifurcated Conversion Option in a Convertible Debt Instrument When
      the Conversion Option No Longer Meets the Bifurcation Criteria in FASB Statement
      No. 133, Accounting for Derivative Instruments and Hedging Activities" (“EITF
      06-7”). At the time of issuance, an embedded conversion option in a convertible
      debt instrument may be required to be bifurcated from the debt instrument and
      accounted for separately by the issuer as a derivative under FAS 133, based
      on
      the application of EITF 00-19. Subsequent to the issuance of the convertible
      debt, facts may change and cause the embedded conversion option to no longer
      meet the conditions for separate accounting as a derivative instrument, such
      as
      when the bifurcated instrument meets the conditions of Issue 00-19 to be
      classified in stockholders’ equity. Under EITF 06-7, when an embedded conversion
      option previously accounted for as a derivative under FAS 133 no longer meets
      the bifurcation criteria under that standard, an issuer shall disclose a
      description of the principal changes causing the embedded conversion option
      to
      no longer require bifurcation under FAS 133 and the amount of the liability
      for
      the conversion option reclassified to stockholders’ equity. In addition, under
      the EITF, for conversion of option for which the carrying amount has previously
      been reclassified to shareholders' equity, the issuer should recognize any
      unamortized discount remaining at the date of conversion immediately as interest
      expense. EITF 06-7 should be applied to all previously bifurcated conversion
      options in convertible debt instruments that no longer meet the bifurcation
      criteria in FAS 133 in interim or annual periods beginning after December 15,
      2006, regardless of whether the debt instrument was entered into prior or
      subsequent to the effective date of EITF 06-7. Earlier application of EITF
      06-7
      is permitted in periods for which financial statements have not yet been issued.
      The Company is currently evaluating the impact of this guidance on its
      consolidated financial statements.




F-20


**BLUEPHOENIX
      SOLUTIONS LTD.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**




**Note
      2 – Certain Transactions:**




In
      order
      to enhance the Company’s solutions and services portfolio, the Company have been
      pursuing a strategy of adding new technologies to its suite of automated
      modernization tools. The Company implements this strategy via internal
      development of new software tools and through acquisitions and investments.
      Accordingly, the Company invests in businesses that develop software tools
      that
      are complementary to its existing portfolio.




**A.**
            **CodeStream
                Software Ltd.:**




In
      December 2006, the Company acquired from a company incorporated in the United
      Kingdom, CodeStream Software Ltd., certain business activities in the field
      of
      modernization of legacy databases, particularly IDMS and other mainframe
      platforms. Pursuant to the purchase agreement, the Company hired 18 persons
      previously employed by CodeStream and assumed all the obligations in respect
      of
      the purchased activities. In consideration thereof the Company paid CodeStream **₤** 5.2
      million (approximately $10.2 million).




In
      addition, the Company undertook to issue to CodeStream a convertible debenture
      in a principal amount of **₤** 2.9
      million (approximately $5.7 million), if, (i) not later than December 14, 2008,
      the Company receive purchase orders from a key customer of CodeStream, in an
      aggregate amount of not less than **₤** 2.2
      million (approximately $4.3 million) ,
      and
      (ii) such purchase orders are collectible under the purchase orders not later
      than December 14, 2009. The debenture shall be issued upon the fulfillment
      of
      the aforementioned conditions and shall be due two years after the date of
      issuance. The debenture shall bear interest at a rate of LIBOR plus 1.5%
      calculated on a quarterly basis. Interest shall be calculated on the principal
      amount of the debenture beginning on December 14, 2006.





In
      addition, the Company undertook to issue to CodeStream a second convertible
      debenture in a principal amount of **₤** 500,000
      (approximately $982 thousand), if (i) not later than December 14, 2010, the
      Company receives an additional purchase orders from the same key customer of
      CodeStream, in an aggregate amount of not less than **₤** 800,000
      (approximately $1.6 million), and (ii) such purchase orders are collectible
      not
      later than 36 months after the first debenture was issued. The debenture shall
      be due two years after the date of issuance and shell bear interest at a rate
      of
      LIBOR plus 1.5% calculated on a quarterly basis. Interest will accrue on the
      principal amount of the debenture beginning on the date of issuance of the
      first
      debenture.




F-21


**BLUEPHOENIX
      SOLUTIONS LTD.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**




**Note
      2 – Certain Transactions (cont.):**




**A.**
            **CodeStream
                Software Ltd. (cont.):**




The
      debentures will be convertible into BluePhoenix’s ordinary shares at a
      conversion rate of $6.00 per ordinary share, subject to adjustment for stock
      dividends, stock splits, recapitalization and other similar events. At the
      request of the holders of the debentures, given six months in advance, the
      Company will repay the amount of the debentures prior to their respective due
      dates. At the request of the holders of a majority of the shares underlying
      each
      of the debentures, given within 10 business days after issuance of the
      debenture, the Company will file a registration statement under the Securities
      Act 1933, referred to as the Securities Act, for an offering of the shares
      underlying the debentures. In addition, if the Company otherwise proposes to
      register its ordinary shares under the Securities Act, the holders of the
      debentures may request that the Company register their underlying shares as
      well, subject to certain limitations. In the event that the repayment date
      of a
      debenture occurs earlier than 6 months after the registration statement becomes
      effective, then the repayment date of the debenture shall be postponed until
      a
      date which is 6 months after the effective date of the registration statement.
      In the event that holders of 50% or more of the principal amount of a debenture
      request repayment of the debenture prior to its due date, the Company shall
      be
      released from its undertakings with respect to the registration described
      above.




Since
      CodeStream's activity constitutes a "business" in accordance with EITF 98-3
      "Determining Whether a Non-monetary Transaction Involves Receipt of Productive
      Assets of a Business", the acquisition was accounted under the guidelines of
      SFAS 141 "Business Combinations".




Accordingly,
      the consideration of the acquisition was attributed to net assets acquired
      and
      liabilities assumed based on their fair value. Upon a purchase price allocation
      performed by an independent appraisal, an amount of $4.6 million was allocated
      to CodeStream's core technology to be amortized over 5 - years period, and
      an
      amount of $0.5 million was allocated to estimated fair value of the customer
      related intangible assets, which is being amortized over its estimated useful
      life - currently 5 years, and an amount of $5.8 million was allocated to
      goodwill. The future contingent consideration, if established, will be recorded
      as goodwill.




F-22


**BLUEPHOENIX
      SOLUTIONS LTD.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**




**Note
      2 – Certain Transactions (cont.):**




**A.**
            **CodeStream
                Software Ltd. (cont.):**




The
      following table summarizes the fair values of assets acquired and liabilities
      assumed as of the date of purchase:




**(in thousands)**Current
                assets
            
            $
            44Property
                and equipment, net
            
            
            285Goodwill
            
            
            5,778Technology
            
            
            4,600Customer
                related intangible asset
            
            
            470Total
                tangible and intangible assets acquired
            
            
            11,177Current
                liabilities
            
            
            304Total
                liabilities assumed
            
            
            304Net
                assets acquired
            
            $
            10,873





**B.**
            **BluePhoenix
                Solutions Srl (previously known as AlphaTech (2000)
                Srl):**




In
      December 2002, the Company purchased a 65% controlling interest in AlphaTech
      (2000) Srl. (“AlphaTech”) from Intercomp for an aggregate consideration of $100
      thousand. In February 2005, the Company entered into an agreement with the
      other
      shareholder of AlphaTech to purchase for $250 thousand its entire holdings
      in
      AlphaTech, which
      as
      of such date was equal to 35% of
      AlphaTech’s outstanding share capital. In 2005, AlphaTech changed its name to
      BluePhoenix Solutions Srl. BluePhoenix Solutions Srl., a company incorporated
      in
      Romania, serves as the Company’s offshore delivery center in
      Romania.





**C.**
            **CePost:**




In
      January 2004, the Company purchased the entire outstanding share capital of
      CePost Ltd., an Israeli Company that develops and markets software solutions
      for
      electronic document mining, management, and presentment. Pursuant to the
      purchase agreement, the Company paid $172.5 thousand to the shareholders of
      CePost and issued to them 31,496 of BluePhoenix’s ordinary shares, valued at the
      fair value of $200 thousand. In addition, the Company undertook to pay to the
      sellers royalties from CePost’s revenues in an amount of up to $1.5 million. At
      its option, the Company may pay the contingent consideration in the form of
      BluePhoenix’s ordinary shares.




F-23


**BLUEPHOENIX
      SOLUTIONS LTD.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**




**Note
      2 – Certain
      Transactions (cont.):**




**C.**
            **CePost
                (cont.):**




At
      acquisition, the Company accounted for the contingent purchase consideration
      at
      the minimum level of $120 thousand, in accordance with SFAS No. 141 and will
      be
      accounted as an additional cost of the acquired entity. In accordance with
      the
      purchase agreement, the Company paid the sellers in 2005 and 2006 advances
      in an
      aggregate amount of $45 thousand on account of the contingent consideration.
      In
      accordance with CePost results, there was no need to update the contingent
      purchase consideration since acquisition.




The
      fair
      value assigned to CePost’s technologies was $553 thousand and it is being
      amortized over a 5-year period.




**D.**
            **Outlook:**




Effective
      as of January 2004, the Company acquired from an Israeli Company, Outlook
      Systems Ltd. through a new wholly-owned subsidiary, Outlook & BluePhoenix
      Ltd., Outlook Systems’ entire business activities in Israel in the field of
      software development services. Pursuant to the purchase agreement, the Company
      hired 31 employees previously employed by Outlook Systems and assumed all the
      obligations in respect of the purchased activity. Under the purchase agreement,
      as amended in 2006, the Company paid to Outlook Systems an aggregate amount
      of
      approximately $1.3 million.




In
      accordance with the amendment to the purchase agreement, a guarantee provided
      by
      the company to secure bank loans of Outlook Systems was cancelled. In addition,
      Outlook Systems received 138,591 of BluePhoenix’s ordinary shares. As part of
      the amendment, the Company undertook to pay Outlook Systems consideration to
      be
      calculated based on Outlook & BluePhoenix Ltd.’s annual earnings before
      interest and taxes, referred to as EBIT, during the three-year period commencing
      on July 1, 2005, as follows:




·
            For
                an amount of up to $300,000 of the annual EBIT in each year within
                the
                three-year EBIT period, the Company will pay Outlook Systems consideration
                equal to 10% of the EBIT;


·
            For
                an amount of annual EBIT in a fiscal year within the three-year EBIT
                period in excess of $300,000, the Company will pay Outlook Systems
                an
                additional consideration equal to 15% of the excessive
                amount.




The
      value
      assigned to the customer related intangible asset amounted to $425 thousand,
      and
      it is being amortized over its estimated useful life-currently 6 years.




During
      2005, the Company recorded an amount of $1.3 million as an additional payment
      which was allocated to goodwill based upon a purchase price allocation performed
      by the Company at acquisition date.




Based
      on
      the EBIT during the 18 months commencing on July 1, 2005, the accrued contingent
      consideration is $35 thousand which was recorded as goodwill.




F-24




**BLUEPHOENIX
      SOLUTIONS LTD.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**




**Note
      2 – Certain Transactions (cont.):**




**E.**
            **Intercomp:**




In
      1998,
      the Company invested in Intercomp Ltd., (“Intercomp”), which has developed a set
      of automated analysis and reengineering tools for legacy COBOL applications.
      During 2002 and 2003, Intercomp focused its efforts on the development of
      software tools that comprise a part of the Company’s LogicMiner
      tool.




In
      2004,
      the Company exercised an option granted to the company, to purchase from a
      former shareholder of Intercomp all of his holdings in Intercomp, consisting
      of
      18.5% of the outstanding share capital of Intercomp. In consideration, the
      Company issued to the selling shareholder warrants to purchase BluePhoenix
      ordinary shares which expired without being exercised. As part of the
      transaction with the former shareholder, certain shareholders of Intercomp,
      holding 2.1% of Intercomp’s outstanding share capital, transferred their
      holdings in Intercomp to the Company. In addition, the remaining shareholders
      of
      Intercomp comprised of several funds acting through their general partner,
      Israel Infinity Venture Capital Partners Ltd., referred to as Infinity,
      converted certain outstanding loans owed to it by Intercomp into 7,236 shares
      of
      Intercomp at a price of $162.70 per share. Following these transactions, the
      Company’s holdings in Intercomp increased from 49% to approximately 62%. Since
      the end of the first quarter of 2004, the Company consolidates the results
      of
      operations of Intercomp.




Concurrently
      with the grant by the former shareholder of the option to purchase from him
      his
      holdings in Intercomp, Intercomp granted nonexclusive rights to a distributor
      partially owned by the former shareholder, to further develop and distribute
      Intercomp’s products.





In
      April
      2004, Infinity granted the Company a call option to purchase its entire holdings
      in Intercomp. The option expired without being exercised by the Company. As
      a
      result, Infinity exercised a put option granted to it, to cause the Company
      to
      purchase Infinity’s entire holdings in Intercomp. In consideration for
      Intercomp’s shares, the company issued to Infinity 100,719 BluePhoenix ordinary
      shares in the first quarter of 2007. As previously agreed with Infinity, the
      Company filed a registration statement under the Securities Act with respect
      to
      the ordinary shares issued to Infinity. Subsequent to the exercise of the option
      by Infinity, the Company currently wholly owns Intercomp.




In
      the
      first quarter of 2006, FIMI, a creditor of Intercomp, has completed exercising
      a
      put option to sell to the Company convertible promissory notes issued by
      Intercomp, in an aggregate principal amount of $3.5 million. The put option
      was
      originally granted to FIMI in January 2001. As consideration thereof, the
      Company paid FIMI an aggregate amount of $4.48 million including interest
      accrued, which equals the book value of the promissory notes, and issued to
      FIMI
      warrants to purchase 210,000 BluePhoenix ordinary shares at an exercise price
      of
      $4.00 per share. No gain or loss was recorded at the repayment date. In the
      first quarter of 2007 FIMI exercised all its warrants.





F-25


**BLUEPHOENIX
      SOLUTIONS LTD.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**




**Note
      2 – Certain Transactions (cont.):**




**F.**
            **M.S.I.
                MultiConn Solutions and MultiConn
                Technologies:**





In
      1999,
      the Company acquired 51% of the outstanding share capital of M.S.I. MultiConn
      Solutions International (1995) Ltd. (“M.S.I. MultiConn”). M.S.I. MultiConn’s
      results of operations were consolidated in the Company’s financial statements
      beginning with the third quarter of 1999. In 2000, the Company increased its
      holding in M.S.I. MultiConn to 60%. Effective as of January 2004, the other
      shareholders of M.S.I. MultiConn transferred their entire holdings in M.S.I
      MultiConn to the Company. Following this transaction, the Company assumed
      control over the daily management of M.S.I. MultiConn. The Company currently
      wholly owns the entire share capital of M.S.I MultiConn and finances its
      activities.




In
      2000,
      the Company established together with the other shareholders of M.S.I. MultiConn
      a company named MultiConn Technologies Ltd. and initially owned 19% of its
      share
      capital.




MultiConn
      Technologies develops and markets BluePhoenixTM SOA - Ready Enablement.




In
      2002,
      the Company increased its holdings in MultiConn Technologies to 60%. Since
      the
      first quarter of 2003, the Company has recorded the investment under the equity
      method and did not consolidate the results of operations of MultiConn
      Technologies, due to lack of control.





Following
      a transaction entered into between the Company and the other shareholders of
      MultiConn Technologies in 2004, the other shareholders of MultiConn Technologies
      increased their holdings in MultiConn Technologies to 58.2% in the aggregate,
      through  the
      issuance of shares by MultiConn Technologies. As a result, the Company currently
      holds approximately 40% of the outstanding share capital of MultiConn
      Technologies. The Company has an option to increase its holdings in MultiConn
      Technologies to 60% for an exercise price of $50 thousand.





In
      2004,
      the Company included in losses of affiliated companies 100% of the losses of
      MultiConn Technologies.





In
      2004,
      the Company did not recognize any gain in the above-mentioned
      transaction.





The
      Company is deemed the primary beneficiary of MultiConn Technologies in
      accordance with FIN 46R “Consolidated of Variable Interest Entities,” and
      accordingly consolidated MultiConn Technologies in its financial statements
      commencing December 31, 2004 and thereafter. The adoption of FIN 46R has no
      impact on the Company’s net income since it has already recorded 100% of
      MultiConn Technologies losses in 2004 under the equity method.




F-26


**BLUEPHOENIX
      SOLUTIONS LTD.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**




**Note
      2 – Certain Transactions (cont.):**




**G.**
            **I-Ter/Informatica
                & Territorio S.p.A.:**




In
      the
      second quarter of 2005, the Company entered into an agreement to purchase the
      entire outstanding share capital of I-Ter/Informatica & Territorio S.p.A.
      (“I-Ter”). Pursuant to the purchase agreement, the Company paid to the selling
      shareholders of I-Ter $1.4 million. Under the terms of the transaction, the
      Company agreed to pay the selling shareholders an additional consideration
      of up
      to $720 thousand based on I-Ter’s cumulative earnings before interest and taxes,
      referred to as EBIT. As agreed, if the EBIT in any calendar year during the
      three-year period commencing on January 1, 2005, is equal to or greater than
      $6
      thousand, the Company will pay the selling shareholders an additional $240
      thousand with respect to each such year. In
      2006
      the Company paid $240 thousand since I-Ter met the criteria in fiscal 2005.
      Since the EBIT in 2006 exceeded the minimal level, the Company recorded a
      contingent consideration in the amount of $240 thousand as
      goodwill.





In
      addition, the Company agreed to pay to the selling shareholders, at such date
      that is 15 business days following the date on which the EBIT report for the
      year ended on December 31, 2007 is final, an additional consideration equal
      to
      seven times the yearly average EBIT in the three-year period commencing on
      January 1, 2005, less the amounts already paid to the selling shareholders
      for
      the purchased shares. In addition, in the event that the yearly average EBIT
      in
      the three-year period commencing on January 1, 2005 is greater than $600
      thousand, the Company shall pay the selling shareholders an amount equal to
      nine
      times of the difference between the yearly average EBIT in the three-year period
      commencing on January 1, 2005 and $600 thousand.





The
      consideration for the acquisition was attributed to net assets on the basis
      of
      fair value of assets acquired and liabilities assumed. Based upon a purchase
      price allocation performed by the Company, an amount of $498 thousand was
      allocated to the estimated fair value of the customer related intangible assets,
      which is being amortized over its estimated useful life - currently 3
      years.




An
      amount
      of $1,158 thousand of the purchase price was allocated to I-Ter’s core
      technology and is being amortized over 5-year period.





During
      the years 2005 and 2006 the Company accounted for the contingent purchase
      consideration in a total amount of $480 thousand as goodwill in respect for
      those years, based upon a purchase price allocation performed by the Company
      at
      the acquisition date, in accordance with SFAS No. 141.




F-27


**BLUEPHOENIX
      SOLUTIONS LTD.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**




**Note
      2 – Certain Transactions (cont.):**




**G.**
            **I-Ter/Informatica
                & Territorio S.p.A.
                (cont.):**




The
      following table summarizes the fair values of the assets acquired and
      liabilities assumed with reference to I-Ter’s balance sheet as of the date of
      purchase.




**(in thousands)**Current
                assets
            
            $
            1,336Other
                long term intangible assets
            
            
            70Property
                and equipment, net
            
            
            100Customer
                related intangible asset(1)
            
            
            498Technology(2)
            
            
            1,158Total
                tangible and intangible assets acquired
            
            
            3,162Current
                liabilities
            
            
            1,360Other
                long term liabilities
            
            
            374Total
                liabilities assumed
            
            
            1,734Net
                assets acquired
            
            $
            1,428




(1)
            The
                value assigned to customer related intangibles is being amortized
                currently over 3 years.


(2)
            The
                value assigned to technology is being amortized currently over 5
                years.




**H.**
            **Zulu
                Software Inc.:**




In
      February 2005, the Company entered into an agreement to purchase up to 20%
      of
      the outstanding share capital of Zulu Software, Inc. (“Zulu”), on a fully
      diluted basis. Under the purchase agreement, the purchase price was divided
      into
      four installments, each to be paid subject to fulfillment of certain milestones.
      The company paid the first installment of $350 thousand in February 2005 against
      the issuance of 8% of Zulu’s outstanding share capital. The Company did not make
      additional payments since the agreed upon milestones have not been
      met.




In
      January 2006, the Company purchased from the other shareholders of Zulu
      additional shares increasing its holdings to 72% of Zulu’s outstanding share
      capital. The aggregate consideration paid for this additional purchase was
      $2.4
      million.





F-28


**BLUEPHOENIX
      SOLUTIONS LTD.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**




**Note
      2 – Certain Transactions (cont.):**




**H.**
            **Zulu
                Software Inc. (cont.):**




The
      consideration for the acquisition was attributed to net assets on the basis
      of
      fair value of assets acquired and liabilities assumed. Based upon a purchase
      price allocation, the purchase price was allocated to the purchased technology
      and is amortized over 5 - years period.





The
      following table summarizes the fair values of the assets acquired and
      liabilities assumed with reference to Zulu’s balance sheet as of the date of
      purchase.




**(in thousands)**Current
                assets
            
            $
            5Property
                and equipment, net
            
            
            4Technology
            
            
            3,477Total
                tangible and intangible assets acquired
            
            
            3,486Current
                liabilities
            
            
            340Other
                long term liabilities
            
            
            425Total
                liabilities assumed
            
            
            765Net
                assets acquired
            
            $
            2,721




**I.**
            **Unaudited
                Pro Forma Information:**




The
      following unaudited pro forma summary presents information as if the acquisition
      of Zulu and CodeStream's activity had occurred as of January 1, 2006, and 2005
      and as if the acquisition of I-Ter had occurred as of January 1, 2005 and 2004.
      The pro forma information, which is provided for informational purposes only,
      is
      based on historical information and does not necessarily reflect the results
      that would have occurred, not is it necessarily indicative of future results
      of
      operations of the consolidated entity.




**Year ended****December 31,****2006**
            
            **2005**
            
            **2004****(In thousands, except per share data)****(Unaudited)**Revenues
            
            $
            69,773
            
            $
            61,301
            
            $
            57,671Net
                income (loss)
            
            $
            3,599
            
            $
            (1,618
            )
            $
            (200
            )Earning
                (loss) per share - basic
            
            
            0.26
            
            
            (0.12
            )
            
            (0.01
            )Earning
                (loss) per share - diluted
            
            
            0.25
            
            
            (0.12
            )
            
            (0.01
            )


F-29


**BLUEPHOENIX
      SOLUTIONS LTD.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**




**Note
      2 - Certain Transactions (cont.):**




**J.**
            **Cicero
                Inc. (formerly known as Level 8 Systems Inc.)**




As
      of
      December 31, 2006. the Company holds several capital instruments, including
      warrants and rights to receive warrants exercisable into shares of Cicero Inc.
      (“Cicero”). If the Company exercises these capital instruments in full, it will
      hold approximately 545,000 ordinary shares of Cicero. During 2003 and the first
      quarter of 2004 the company sold substantially all of the shares of Cicero
      held
      by the Company for $624 thousand.





The
      Company provides Bank Ha’Poalim with a guarantee securing Cicero’s bank loans,
      in an amount of approximately $2 million. The guarantee is extended from time
      to
      time and it is currently in effect until November 2007.  In
      consideration for the extension of the guarantee, Cicero issues the Company
      ordinary shares. In the event that the guarantee is exercised, the bank is
      obligated to grant the Company a three-year loan in an amount of up to the
      amount of the guarantee.




In
      September 2004, the Company extended a loan granted to Cicero of approximately
      $97 thousand under a secured promissory note. The note bears interest at an
      annual rate of 10%. In consideration, the Company is entitled to receive
      warrants to purchase 19,865 ordinary shares of Cicero at an exercise price
      of $1
      per share.





**Note
      3 - Property and Equipment, Net:**




Composition
      of property and equipment, grouped by major classifications:




**December 31,****2006**
            
            **2005****(in thousands)****Cost:**Computers
                and peripheral equipment
            
            $
            9,887
            
            $
            8,954Office
                furniture and equipment
            
            
            1,268
            
            
            1,403Leasehold
                improvements
            
            
            645
            
            
            644Motor
                vehicles
            
            
            292
            
            
            46412,092
            
            
            11,465**Accumulated
                Depreciation:**Computers
                and peripheral equipment
            
            
            8,565
            
            
            7,866Office
                furniture and equipment
            
            
            874
            
            
            872Leasehold
                improvements
            
            
            398
            
            
            358Motor
                vehicles
            
            
            108
            
            
            2099,945
            
            
            9,305**Depreciated
                cost**
            
            $
            2,147
            
            $
            2,160




Depreciation
      expenses totaled $849, $1,058, and $1,380 thousand for the years ended December
      31, 2006, 2005, and 2004, respectively.




F-30




**BLUEPHOENIX
      SOLUTIONS LTD.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**Note
      4 - Goodwill:**




**December
                31,****2006**
            
            **2005****(in
                thousands)**Carrying
                amounts at beginning of year
            
            $
            38,832
            
            $
            37,090Acquired
            
            
            6,006
            
            
            1,742Carrying
                amount at end of year
            
            $
            44,838
            
            $
            38,832




**Note
      5 - Software Development Costs and Other:**




**A.**
                **Composition:**






**December
                  31,****2006**
              
              **2005****(in
                  thousands)**Software
                  development costs (1)
              
              $
              34,823
              
              $
              25,810Customer
                  related intangible assets (2)
              
              
              1,067
              
              
              453Deferred
                  issuance expenses, net
              
              
              738
              
              
              328Rent
                  deposit
              
              
              57
              
              
              119Deferred
                  tax asset
              
              
              -
              
              
              13Others
              
              
              141
              
              
              177$
              36,826
              
              $
              26,900(1)Original
                  amount
              
              $
              55,430
              
              $
              39,287Less - accumulated amortization
              
              
              20,607
              
              
              13,477$
              34,823
              
              $
              25,810(2)Original
                  amount
              
              $
              1,576
              
              $
              923Less
                  - accumulated amortization
              
              
              509
              
              
              470$
              1,067
              
              $
              453




The
      estimated aggregate amortization of customer related intangible asset for the
      following years is as follows: 2007: $374 thousand, 2008: $255 thousand, 2009:
      $210 thousand,: 2010: $148, and 2011: $80 thousand.




F-31




**BLUEPHOENIX
      SOLUTIONS LTD.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**Note
      6 - Short-Term Bank Credit and Other:**




**Composition:**




**AverageInterest rate****December 31,**
              
              
              
              **December
                  31,****2006**
              
              **Linkage**
              
              **2006**
              
              **2005****%**
              
              **Basis**
              
              **(in
                  thousands)**Bank
                  overdraft and loans
              
              
              7.5
              
              
              NIS
              
              $
              27
              
              $
              2,654Short-term
                  bank loans
              
              
              -
              
              
              CPI
              
              
              -
              
              
              12Short-term
                  bank loans
              
              
              -
              
              
              Dollar
              
              
              -
              
              
              5,556Promissory
                  note to Fimi
              
              
              -
              
              
              Dollar
              
              
              -
              
              
              4,293Short-term
                  bank loans
              
              
              5.98
              
              
              Euro
              
              
              55
              
              
              1,580Current
                  portion of long-term bank loan
              
              
              5.84
              
              
              Euro
              
              
              527
              
              
              -$
              609
              
              $
              14,095





**Note
      7 – Accrued Severance Pay, Net:**




**A.**
            **Accrued
                Liability:**




The
      Company is liable for severance pay to its employees pursuant to the applicable
      local laws prevailing in the respective countries of employment and employment
      agreements. For Israeli employees, the liability is partially covered by
      individual managers’ insurance policies under the name of the employee, for
      which the Company makes monthly payments. The Company may make withdrawals
      from
      the managers’ insurance policies only for the purpose of paying severance
      pay.





The
      amounts accrued and the amounts funded with managers’ insurance policies are as
      follows:




**December
                31,****2006**
            
            **2005****(in
                thousands)**Accrued
                severance pay
            
            $
            5,769
            
            $
            4,733Less
                - amount funded
            
            
            4,051
            
            
            3,424$
            1,718
            
            $
            1,309





**B.**
            **Expenses:**




The
      expenses related to severance pay for the years ended December 31, 2006, 2005,
      and 2004 were $925, $383, and $766 thousand, respectively.




F-32




**BLUEPHOENIX
      SOLUTIONS LTD.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**Note
      8 – Provision for Losses in Formerly-consolidated
      Subsidiary:**




Liraz,
      a
      wholly owned subsidiary of the company, is liable for losses in a former
      subsidiary it had consolidated until the second quarter of 2001. The provision
      for such liability as of December 31, 2006 and December 31, 2005, was accounted
      for under SFAS No. 5 and amounted to $2 million, representing the maximum
      potential amount Liraz has guaranteed to secure a bank loan of the said
      subsidiary. Under its terms, such guarantee may be reduced to the extent that
      the subsidiary raises additional share capital. The guarantee will be
      outstanding until November 2007 (see also Note 2J, with respect to the
      investment in Cicero).





**Note
      9 – Loans from Banks and Others:**






**A.**
            **Composition:****December 31,2006**
            
            
            
            **December 31, 2006**
            
            **December 31, 2005****AverageInterest
                rate**
            
            **Linkage**
            
            **Long-termliabilities**
            
            **Currentportion**
            
            **Total
                long-termliabilities net ofcurrent
                portion**
            
            **Total
                long-termliabilities net ofcurrent
                portion****%**
            
            **Basis**
            
            **(in
                thousands)**
            
            **(in
                thousands)**7.28
            
            
            Dollar
            
            $
            10,554
            
            $
            -
            
            $
            10,554
            
            $
            3,836-
            
            
            NIS
            
            
            -
            
            
            -
            
            
            -
            
            
            1,6945.83
            
            
            Euro
            
            
            10,000
            
            
            527
            
            
            9,473
            
            
            2,859$
            20,554
            
            $
            527
            
            $
            20,027
            
            $
            8,389





*
            The
                loans bear interest based on the
                LIBOR.


In
      connection with certain loan agreements, the Company committed to certain
      covenants related to its operation – see Note 10.A.10. As of December 31, 2006,
      The Company met all such financial covenants.





**B.**  **Long-term
      Loans from Banks and Other are Due as Follows:**




**December
                31,****2006**
            
            **2005****(in
                thousands)**First
                year (current portion)
            
            $
            527
            
            $
            355Second
                year
            
            
            7,558
            
            
            2,227Third
                year
            
            
            1,620
            
            
            4,150Fourth
                year and thereafter
            
            
            10,849
            
            
            2,012**Total**
            
            $
            20,554
            
            $
            8,744




F-33


**BLUEPHOENIX
      SOLUTIONS LTD.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**




**Note
      10 - Commitments and Contingencies:**




**A.**
            **Commitments:**




**1.**
            The
                Company is obligated to pay management fees to Formula in an annual
                amount
                equal to 3% of the revenues, but not more than $180
                thousand.




**2.**
            The
                Company rents its offices, vehicles and, other equipment under various
                operating lease agreements. Aggregate minimum rental commitments
                under
                non-cancelable leases as of December 31, 2006 were as
                follows:




**Office Facilities**
            
            **Vehicles,**
              **Equipment, and**
              **Other**Fiscal
                2007
            
            $
            1,837
            
            $
            1,226Fiscal
                2008
            
            
            1,209
            
            
            800Fiscal
                2009
            
            
            258
            
            
            244Fiscal
                2010
            
            
            119
            
            
            4Thereafter
            
            
            44
            
            
            -$
            3,467
            
            $
            2,274





**3** .  Under
      agreements between the Company and certain of its customers, the Company
      undertook to provide such customers a bank guarantee for the assurance of
      performance of its obligations under its agreements with such customers. As
      of
      December 31, 2006, there are outstanding bank guarantees on behalf of customers
      in the aggregate amount of $360 thousand.




**4.**
            Through
                December 31, 2006, Mainsoft entered into a grant agreement with the
                OCS,
                for the development of Visual MainWin for J2EE.




Royalties
      of 3% are payable to the OCS on sales of Visual MainWin for J2EE up to 100%
      of
      the dollar-linked grant received with regard to funded product.





The
                balance of the contingent liability relating to the above royalties
                as of
                December 31, 2006 amounted to approximately $1.8
                million.





**5.**  As
      of
      January 1, 2004 a wholly owned subsidiary entered into a grant agreement with
      the OCS, for the development of PowerText. Royalties of 3% are payable to the
      OCS on sales of PowerText up to 100% of the dollar-linked grant received with
      regard to the funded product. As of December 31, 2006 the balance of the
      contingent liability relating to the above royalties amounted to approximately
      $235 thousand.




F-34


**BLUEPHOENIX
      SOLUTIONS LTD.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**Note
      10 - Commitments and Contingencies (cont.):**




**A.**
            **Commitments
                (cont.):**




**6.**  Through
      December 31, 2004, MultiConn Technologies entered into a grant agreement with
      the OCS, for the development of WS4Legacy, (formerly known as eXperanto).
      Royalties of 3% are payable to the OCS on sales of WS4Legacy up to 100% of
      the
      dollar-linked grant received in regard to the funded product.




The
      balance of the contingent liability relating to the above royalties at December
      31, 2006 amounted to approximately $615 thousand.





**7.**  As
      to a
      guarantee of debt by Cicero - see Note 8.





**8.**  In
      2004,
      the Singapore-Israel Industrial Research and Development Foundation agreed
      to
      provide a wholly owned subsidiary of the Company together with a Company
      incorporated in Singapore, financing for the development of a Java report
      generator based on legacy text file input. Accordingly, the foundation agreed
      to
      award the subsidiary up to $100 thousand repayable according to an agreed
      schedule. As of December 31, 2006, the subsidiary received $45 thousand of
      the
      grant. The grant is required to be repaid in installments based on sales of
      the
      funded product up to the amount of the grant.





**9.**
            The
                Company’s subsidiary, I-Ter, is entitled to funds to developeEasy4Plan
                product from the Ministry of Production in Italy. Easy4Plan is a
                workflow
                management tool designed for ISO9000 companies. Approximately 30%
                of the
                funds are a grant, and the balance is an 8-year loan to be repaid
                by
                I-Ter. The loan bears a minimal annual interest. The development
                period
                ended in September 2006.Pending
                the final approval of the Ministry of Production,the Company anticipates that during 2007I-Ter
                will receive a total aggregate amount of$650
                thousand.





**10.** In
      connection with the credit line extended to the Company by Bank Leumi Le’Israel
      Ltd., Bank Discount Le’Israel Ltd, Bank Ha’Poalim Ltd., and the First
      International Bank Ltd., the Company committed to certain covenants related
      to
      its operation such as:





a)
              Maintaining
                  a minimum level of shareholders’ equity of no less than 40% of the
                  Company’s total assets and no less than $40
                  million;


b)
            Maintaining
                a level of annual operating income before depreciation and amortization
                of
                no less than $5 million; and





c)
            Maintaining
                the ratio of the Company bank liabilities to current assets, excluding
                other current assets, of no more than
                55%.




F-35


**BLUEPHOENIX
      SOLUTIONS LTD.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**Note
      10 - Commitments and Contingencies (cont.):**




**A.**
            **Commitments
                (cont.):**




**10.** **(Cont.)**




As of December 31, 2006, the Company met all such financial
      covenants.





No
      liability was recorded in the Company’s financial statements with respect to the
      guarantees mentioned **** above,
      except for the guarantee on behalf of Cicero (see Note 8),





**B.**
            **Contingencies:**




**1.**  In
      July
      2003, a former Liraz shareholder filed an application with the Tel-Aviv-Jaffa
      District Court to approve a claim filed by him against the Company, as a class
      action. The claim relates to the acquisition of Liraz shares that the Company
      completed in March 2003. The shareholder alleges that the share price that
      the
      Company paid to Liraz’s shareholders in the tender offer and in a subsequent
      mandatory purchase was lower than the fair price of Liraz shares. The maximum
      amount of the claim is approximately $7.3 million in the aggregate. Under
      Israeli law, the court’s approval is required for the plaintiff to represent all
      of the shareholders of Liraz who sold their shareholdings to the Company
      pursuant to the tender offer and the mandatory acquisition. The plaintiff has
      applied for such approval in the lawsuit. The Company believes that the
      allegations against it in this proceeding are without merit and intends to
      vigorously defend the claim and contest the allegations made
      therein.





**2.**  The
      Company evaluates estimated losses for indemnifications due to product
      infringement under SFAS No. 5, “Accounting for Contingencies,” as interpreted by
      FIN 45. At this time, it is not possible to determine the maximum potential
      amount under these indemnification clauses due to lack of prior indemnification
      claims and the unique facts and circumstances involved in each particular
      agreement. Such indemnification agreements may not be subject to maximum loss
      clauses. Historically, we have not incurred material costs as a result of
      obligations under these agreements and we have not accrued any liabilities
      related to such indemnification obligations in our financial
      statements.




F-36




**BLUEPHOENIX
      SOLUTIONS LTD.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**Note
      11 - Shareholders’ Equity:**




**A.**
            **Share
                Capital:**




**1.** On
      January 31, 1997, 3,120,000 ordinary shares of the Company were offered in
      an
      initial public offering (the “IPO”) at a price of $7.50 per share. Since the
      above transaction, the Company’s shares have been traded in the United States on
      the NASDAQ Global Market. Their current symbol is “BPHX.”




**2.**  On
      July
      22, 1997, 1,200,000 ordinary shares of the Company were offered in a second
      public offering, at a price of $27.00 per share, of which 600,000 ordinary
      shares were issued by the Company and 600,000 ordinary shares were sold by
      existing shareholders.




**3.** During
      the years 1998 through 2002, two subsidiaries of the Company purchased a total
      of 1,870,565 the Company’s shares for a total consideration of $14.7 million.
      All of the Company’s ordinary shares have equal voting rights. However, under
      applicable Israeli law, the shares held by the Company’s subsidiaries have no
      voting rights and, therefore, are excluded from the number of its outstanding
      shares. In January 2006, the Company’s subsidiary sold an aggregate of 136,000
      of the shares held by it to Israeli institutional investors in Israel, for
      aggregate consideration of approximately $534 thousand. In February 2006, the
      Company’s subsidiary transferred 86,791 shares to Outlook Systems and
      BluePhoenix issued 51,620 ordinary shares on its behalf (See note
      2.D).




**4.** In
      January 2001, the Company’s ordinary shares were listed for trading on the Tel
      Aviv Stock Exchange under the “Dual Listing” arrangement.




**5.** In
      November 2002, the Company issued to Liraz’s selling shareholders, including
      Formula, 3,478,624 ordinary shares, constituting an aggregate of 26% of the
      Company’s outstanding share capital.




**6.**   In
      the
      first quarter of 2007 FIMI exercised 210,000 warrants (see note
      2.E)




**7.**  In
      the
      first quarter of 2007, the Company issued to Infinity 100,719 ordinary shares
      (see Note 2.E.).





**B.**
            **Share
                Options:**




**1.**  **Employee
      Share Option Plans:**




**a)** **The
      1996 Share Option Plan:**




In
      1996,
      the Company adopted two option plans. One of these option plans was terminated
      after all options granted under it were exercised. Pursuant to the other 1996
      option plan, as amended, the Company reserved 3,700,000 ordinary shares for
      issuance to officers, consultants and employees of the Company and its
      subsidiaries. The exercise price of the options granted under the 1996 option
      plan ranges from $2.25 to $10.50.





F-37




**BLUEPHOENIX
      SOLUTIONS LTD.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**Note
      11 - Shareholders’ Equity (cont.):**




**B.**
            **Share
                Options (cont.):**




**1.**  **Employee
      Share Option Plans (cont.):**




**a)**
            **The
                1996 Share Option Plan
                (cont.):**




The
      total
      fair value of options vested during the year ended December 31, 2006 was $40
      thousand.




Under
      the
      1996 option plan, unless determined otherwise by the Board, options vest over
      a
      three-year period from the date of grant and expire 10 years after grant date.
      Unvested options are forfeited upon termination of employment.




F-38


**BLUEPHOENIX
      SOLUTIONS LTD.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**




**Note
      11 - Shareholders’ Equity (cont.):**




**B.**
            **Share
                Options (cont.):**




**1.**
            **Employee
                Share Option Plans
                (cont.):**




**a)**
                **The
                    1996 Share Option Plan
                    (cont.):**




The
                  following table summarizes information about fixed share options
                  outstanding at December 31,
                  2006:




**Options
                Outstanding**
            
            **Options
                Exercisable****Range
                of**
              **Exercise**
              **Prices**
            
            **Number**
              **Outstanding**
              **on
                December**
              **31,
                2006**
            
            **Weighted**
              **Average**
              **Remaining**
              **Contractual**
              **Life**
            
            **Weighted**
              **Average**
              **Exercise**
              **Price**
            
            **Number**
              **Exercisable**
              **on**
              **December**
              **31,
                2006**
            
            **Weighted**
              **Average**
              **Exercise**
              **Price****$**
            
            
            
            **Years**
            
            **$**
            
            
            
            **$**2.25
            
            
            395,000
            
            
            6.25
            
            
            2.25
            
            
            291,000
            
            
            2.253.00
            
            
            106,701
            
            
            6.50
            
            
            3.00
            
            
            106,701
            
            
            3.003.00
            
            
            63,600
            
            
            5.50
            
            
            3.00
            
            
            63,600
            
            
            3.003.00
            
            
            80,000
            
            
            5.09
            
            
            3.00
            
            
            53,333
            
            
            3.003.50
            
            
            34,700
            
            
            6.50
            
            
            3.50
            
            
            34,700
            
            
            3.504.00
            
            
            200,000
            
            
            6.83
            
            
            4.00
            
            
            200,000
            
            
            4.004.00
            
            
            150,000
            
            
            9.00
            
            
            4.00
            
            
            150,000
            
            
            4.004.50
            
            
            38,533
            
            
            4.50
            
            
            4.50
            
            
            38,533
            
            
            4.504.50
            
            
            63,000
            
            
            8.67
            
            
            4.50
            
            
            63,000
            
            
            4.505.00
            
            
            37,400
            
            
            8.83
            
            
            5.00
            
            
            37,400
            
            
            5.005.00
            
            
            430,712
            
            
            9.00
            
            
            5.00
            
            
            430,712
            
            
            5.005.50
            
            
            13,000
            
            
            3.83
            
            
            5.50
            
            
            13,000
            
            
            5.505.50
            
            
            75,000
            
            
            9.58
            
            
            5.50
            
            
            -
            
            
            5.506.00
            
            
            28,000
            
            
            7.00
            
            
            6.00
            
            
            28,000
            
            
            6.006.00
            
            
            143,721
            
            
            7.42
            
            
            6.00
            
            
            143,721
            
            
            6.006.00
            
            
            150,000
            
            
            8.67
            
            
            6.00
            
            
            150,000
            
            
            6.006.50
            
            
            2,000
            
            
            7.00
            
            
            6.50
            
            
            2,000
            
            
            6.508.00
            
            
            80,000
            
            
            2.50
            
            
            8.00
            
            
            80,000
            
            
            8.009.63
            
            
            43,000
            
            
            3.25
            
            
            9.63
            
            
            43,000
            
            
            9.6310.50
            
            
            88,600
            
            
            4.25
            
            
            10.50
            
            
            88,600
            
            
            10.502,222,967
            
            
            
            
            
            
            
            
            2,017,300








F-39


**BLUEPHOENIX
        SOLUTIONS LTD.**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**


**Note
      11 - Shareholders’ Equity (cont.):**




**B.**
            **Share
                Options (cont.):**




**1.**  **Employee
      Share Option Plans (cont.):**




**b)**
            **Options
                granted to employees of a
                subsidiary:**




In
      August
      2000, in connection with the purchase of a controlling interest in a subsidiary,
      the Company granted options to certain employees of the subsidiary to purchase
      an aggregate of 125,000 of the Company’s ordinary shares of which 55,000 were
      cancelled. The exercise price of the options is $9.625 per share. All of these
      options are currently exercisable. The options shall expire in August
      2010.




Data
      related to the share option plan as of December 31, 2006, 2005 and 2004 and
      changes during the years ended on those dates are as follows:





**2006**
            
            **2005**
            
            **2004****Number**
              **of**
              **Options**
            
            **Weighted**
              **Average**
              **Exercise**
              **Price**
            
            **Number**
              **of**
              **Options**
            
            **Weighted**
              **Average**
              **Exercise**
              **Price**
            
            **Number**
              **of**
              **Options**
            
            **Weighted**
              **Average**
              **Exercise**
              **Price****$**
            
            
            
            **$**
            
            
            
            **$**Options
                outstandingat
                beginning of year
            
            
            2,765,817
            
            
            4.78
            
            
            2,132,587
            
            
            5.00
            
            
            2,159,993
            
            
            4.99Changes
                during the year:Granted
            
            
            75,000
            
            
            5.5
            
            
            834,712
            
            
            4.96
            
            
            163,721
            
            
            6.00Exercised
            
            
            (206,796
            )
            
            3.53
            
            
            (10,299
            )
            
            3.05
            
            
            (33,767
            )
            
            3.56Forfeited
            
            
            (411,054
            )
            
            6.19
            
            
            (191,183
            )
            
            8.04
            
            
            (157,360
            )
            
            6.29Options
                outstandingat
                end of year
            
            
            2,222,967
            
            
            4.60
            
            
            2,765,817
            
            
            4.78
            
            
            2,132,587
            
            
            5.00Options
                exercisable at year-end
            
            
            2,017,300
            
            
            4.71
            
            
            2,399,484
            
            
            4.78
            
            
            877,049
            
            
            6.08Weighted-average
                fair value of options granted during the year*
            
            
            2.65
            
            
            
            
            
            1.47
            
            
            
            
            
            1.71




* The
      fair
      value of each option granted is estimated on the date of grant, using the
      Black-Scholes option-pricing model with the following weighted average
      assumptions: dividend yield of 0% for all years; expected volatility: 2006
      -
      45%, 2005 - 41%, 2004 - 26%; risk-free interest rate: 2006- 4.97%, 2005 - 3.93%,
      2004 - 2.78%; and expected life: 2006 and 2005 - 5.5 years, 2004 - 3
      years.




F-40




**BLUEPHOENIX
      SOLUTIONS LTD.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**




The
      aggregate intrinsic value of outstanding and exercisable options at December
      31,
      2006 was $3,590 thousand and $3,025 thousand, respectively.




The
      Company is required to assume a dividend yield as an input in the Black-Scholes
      model. The dividend yield assumption is based on the Company’s historical
      experience and expectation of future dividends payouts and may be subject to
      change in the future.




The
      Company uses historical volatility in accordance with FAS 123R. The computation
      of volatility uses historical volatility derived from the Company’s
      exchange-traded shares.




The
      risk-free interest assumption is the implied yield currently available on U.S.
      Treasury zero-coupon bonds, issued with a remaining term equal to the expected
      life term of the Company’s options.




As
      permitted by SAB 107, the Company used the simplified method to compute the
      expected option term for options granted in 2006. **Note
      11 - Shareholders’ Equity (cont.):**




**B.**
              **Share
                  Options (cont.):**




**1.**
            **Employee
                Share Option Plans
                (cont.):**




**c)**
            **Acceleration:**




In
      anticipation of the effects that adoption of SFAS No. 123R would
      have,  and
      under
      the Company’s management belief that in the currently increasing competition in
      the labor market, an acceleration may have a positive effect on employee morale
      and retention , th e
      Compensation Committee and Board of Directors approved and made effective on
      December 27, 2005 the acceleration of several unvested stock options. As a
      result, 144,990 and 1,228,997 unvested stock options were accelerated in the
      Company and in its subsidiary, respectively.




**2.**
            **Convertible
                Debentures and Warrants:**




On
      March
      30, 2004, the Company completed a $5 million private placement of convertible
      debentures and warrants to four institutional investors. On February 18, 2005,
      the institutional investors and the Company amended certain terms of this
      transaction.





Pursuant
      to the amended agreement, the debentures are due in 2007 and bear interest
      at a
      rate equal to the six-month LIBOR, paid quarterly in cash or in a number of
      BluePhoenix ordinary shares, at the Company’s discretion. The debentures are
      convertible into BluePhoenix’s ordinary shares at a conversion rate of $5.25 per
      ordinary share, subject to (i) adjustment for stock dividends, stock splits,
      recapitalization and other similar events, and (ii) anti-dilution adjustments.
      Following an event of adjustment in January 2006, the conversion rate of the
      debentures was adjusted to $5.24 per ordinary share. The conversion rate with
      respect to payments of interest on the debentures will be equal to 90% of the
      volume weighted average price of BluePhoenix ordinary shares on the NASDAQ
      Global market during the 20 trading days preceding the date of payment of
      interest. In the event that the volume weighted average price per ordinary
      share
      (as calculated in the preceding sentence) for any 20 consecutive trading days
      exceeds $6.55, the Company may force the holders of the debentures to convert
      any or all of the principal amount of the debentures held by them as of such
      date, subject to, among other things, the Company having an effective resale
      registration statement at such time for the resale of the ordinary shares
      underlying the debentures.




F-41




**BLUEPHOENIX
        SOLUTIONS LTD.**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**




In
      addition to the debentures, the institutional investors were issued warrants
      to
      purchase up to 285,714 BluePhoenix ordinary shares at an exercise price of
      $6.50
      per share, subject to adjustments similar to those pertaining to the conversion
      price of the debentures. The warrants are exercisable during a 5-year period
      commencing September 2004.




**Note** **11
        - Shareholders’ Equity (cont.):**




**B.**
            **Share
                Options (cont.):**




**2.**
            **Convertible
                Debentures and Warrants
                (cont.):**




As
      agreed
      with the investors, the registered shares underlying the debentures and warrants
      are registered for resale under the effective registration statement. In
      accordance with APB No. 14, “Accounting for Convertible Debt and Debt Issued
      with Stock Purchase Warrants,” EITF 98-5, “Accounting for Convertible Securities
      with Beneficial Conversion Features or Contingently Adjustable Conversion
      Rations,” and EITF 00-27, “Application of Issue No. 98-5 to Certain Convertible
      Instruments” (“EITF 00-27”), a portion of the proceeds of the convertible
      debentures issued with detachable warrants was allocated to the warrants and
      to
      the convertible instrument at the time of issuance. Amounts allocated to the
      warrants were accounted for as liabilities, in accordance with EITF 00-19,
      “Accounting for Derivative Financial Instruments Indexed to, and Potentially
      Settled In, a Company’s Own Stock,” and were revalued ,
      based
      on the fair values of the underlying shares, on each reporting date, against
      financial expenses (income). The financial expenses relating to the change
      in
      the value of the warrants derivative amounted to $104 thousand and $45 thousand
      for the years ended 2004 and 2005, respectively.





Since
      any
      future dilutive issuance is under the control of the Company, and the
      anti-dilution adjustment is limited, the Company accounted the debentures as
      conventional convertible instruments.





F-42




As
      a
      result, at the issuance date, a beneficial conversion feature was recorded
      on
      the debentures, in the amount of $173 thousand, since the effective conversion
      price of the debentures was lower than the fair value of the shares on the
      commitment date.




The
      Company applied EITF 96-19 “Debtor’s Accounting for a Modification or Exchange
      of Debt Instruments” and EITF 05-7 “Accounting of Modification to Conversion
      Option Embedded in Debt Securities and Related Issues” to determine the
      accounting for the modification on February 18, 2005. The change in the term
      of
      the convertible debentures was accounted for as a modification of the instrument
      as a result of the application of the 10% test on the modified debenture and
      the
      original debenture. As a result the change in the debt instrument is not
      considered substantially different (less then 10%).




F-43


**BLUEPHOENIX
        SOLUTIONS LTD.**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**




**Note
      11 - Shareholders’ Equity (cont.):**




**B.**
            **Share
                Options (cont.):**




**2.**
            **Convertible
                Debentures and Warrants
                (cont.):**




A
      new
      effective interest rate was determined based on the carrying amount of the
      original debt instrument and the revised cash flows. The deemed discount of
      the
      debentures is deducted from the liability and the issuance expenses, which
      are
      recorded as an asset, and is amortized using the interest method over a period
      of 44 months, the term of the debentures.





The
      difference between the fair value of the conversion option immediately following
      such modification and the fair value immediately prior to the modification,
      was
      recognized as a discount associated with the debt, and the offset to the
      discount was recognized in equity in accordance with EITF 05-7 in the amount
      of
      $325 thousand. The difference between the fair value of the modified warrants
      and the fair value of the original warrants (the warrants are revaluated based
      on the fair values of the underling shares) was deducted from the warrant
      derivative against a discount. The financial expense relating to the
      amortization of the discount of the debentures amounted to $217, $276 and $303
      thousand for the years ended December 31, 2004, 2005 and 2006,
      respectively.





On
      March
      15, 2005, as the Form F-3 relating to the convertible debentures was declared
      effective by the Securities Exchange Commission, the Company classified the
      fair
      value attributed to the warrants as equity. The warrants were revaluated to
      their fair value until such date.





In
      November 2006, several investors converted $178 thousand principal amount of
      the
      debentures into equity and accordingly the company issued 33,800 ordinary
      shares. Consequently, the respective unamortized discount and the beneficial
      conversion feature were charged to earnings.





Pursuant
      to the Company’s agreement with the institutional investors, in March 2006,
      three of the investors exercised their right to purchase additional debentures
      and warrants. Accordingly, the Company issued to the investors debentures in
      an
      aggregate purchase price of $3 million on the same terms as the initial
      debentures, except that the conversion price is $4.50 per share and is due
      in
      2009.





In
      addition, the institutional investors were issued additional warrants on the
      same terms as the initial warrants, to purchase an aggregate of up to 200,000
      BluePhoenix ordinary shares. The warrants are exercisable during a 5-year period
      commencing on September 2006.




F-44


**BLUEPHOENIX
        SOLUTIONS LTD.**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**




**Note
      11 - Shareholders’ Equity (cont.):**




**B.**
            **Share
                Options (cont.):**




**2.**
            **Convertible
                Debentures and Warrants
                (cont.):**




In
      the
      event that the volume weighted average price per ordinary share (as calculated
      in the preceding sentence) for any 20 consecutive trading days exceeds $5.625,
      the Company may force the holders of the debentures to convert any or all of
      the
      principal amount of the debentures held by them as of such date, subject to,
      among other things, the Company having an effective resale registration
      statement at such time for the resale of the ordinary shares underlying the
      debentures.





In
      accordance with APB No. 14, "Accounting for Convertible Debt and Debt Issued
      with Stock Purchase Warrants", a portion of the proceeds of the convertible
      debentures issued with detachable warrants was allocated to the warrants and
      to
      the convertible instrument at the time of issuance. Amounts allocated to the
      warrants were accounted for as liabilities, in accordance with EITF 00-19,
      "Accounting for Derivative Financial Instruments Indexed to, and Potentially
      Settled In, a Company's Own Stock," and were revalued, based on the fair values
      of the underlying shares, on each reporting date, against financial expenses
      (income). The financial income relating to the change in the value of the
      warrants derivative amounted to $9 thousand for the year ended December 31,
      2006.




Since
      the
      debentures include an anti-dilution adjustment and the conversion price is
      not
      fixed, the Company recorded the embedded conversion feature at fair value in the amount of $1.35 million and it's being
      marked to market in accordance with EITF 00-19 and EITF 05-02 "Meaning of
      Conventional Convertible Debt Instrument in Issue No. 00-19". Financial expenses
      relating to the reevaluation of the conversion feature amounted to $82 thousand
      in fiscal 2006.




In
      May
      2006, as the Form
      F-3
      relating to the convertible debentures was declared effective by the Securities
      Exchange Commission, the Company classified the fair value attributed to the
      warrants as equity. The warrants were revaluated to their fair value until
      such
      date.




During
      the fourth quarter of 2006, several investors converted $1 million principal
      amount of the debentures into equity and accordingly were issued 223,333
      ordinary shares. Consequently, the relative carrying amount of the debentures
      and the embedded conversion features were charged to equity.





F-45


**BLUEPHOENIX
        SOLUTIONS LTD.**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**


**Note
      11 - Shareholders’ Equity (cont.):**




**B.**
            **Share
                Options (cont.):**




**3.**
            In
                February 2006, the Company completed an underwritten public offering
                in
                Israel of series A convertible notes in an aggregate principal amount
                of
                NIS 54 million that were equal at that time to approximately $11.5
                million. The price of the notes as determined in the offering was
                98% of
                the principal amount of the notes, and the gross proceeds from the
                offering of the notes totaled $11.2 million. The notes bear interest
                at a
                rate of LIBOR 3 months +1.5% per annum, payable every 3 months beginning
                on May 1, 2006, with the last payment to be made on February 1, 2011.
                The
                principal of the notes is payable in four equal annual installments
                on
                February 1 of each of 2008 through 2011. The principal and interest
                of the
                notes are linked to the U.S. Dollar, with a minimum rate of the issuance
                date exchange rate. Under certain terms, the Company may call for
                an early
                redemption of the notes, after February 1, 2008. The notes are convertible
                into ordinary shares of BluePhoenix at a conversion rate of one ordinary
                share per NIS 26 ($6.15) principal amount of notes, subject to
                adjustments. Holders may convert their notes into BluePhoenix ordinary
                shares on any trading day, beginning on the date the notes were first
                listed for trading until the closing of trade on January 16, 2011.
                The
                convertible notes are not secured.





The
      notes
      are traded on the TASE. The notes and the shares underlying the notes have
      not
      been registered under the Securities Act, and may not be offered or sold in
      the
      United States or to U.S. persons, absent registration or an applicable exemption
      from registration requirements.





The
      minimum level of the exchange rate was accounted for as an embedded put option
      and accordingly was bifurcated from the host debt contract. The put option
      was
      recorded at fair value on the issuance date and is being marked to market in
      accordance with SFAS No 133" Accounting for Derivative Instruments and Hedging
      Activities". During 2006, financial expenses amounted to $808 thousand in
      connection with the granted put option.




F-46


**BLUEPHOENIX
        SOLUTIONS LTD.**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**




**Note
      11 - Shareholders’ Equity (cont.):**




**B.**
            **Share
                Options (cont.):**




**4.**
            **Employee
                Option Plans in a Subsidiary:**




A
      subsidiary granted options to its employees to purchase the subsidiary’s shares.
      The options are exercisable during a 3-year period after the date of grant.
      A
      summary of the status of the option plans as of December 31, 2006 and 2005
      and
      changes during the years then ended is given below:




**2006**
              
              **2005****Number ofOptions**
              
              **WeightedAverageExercisePrice**
              
              **Number ofOptions**
              
              **WeightedAverageExercisePrice**$
              
              
              
              $Options
                  outstanding at beginning of year Changes during the year:
              
              
              4,679,487
              
              
              0.84
              
              
              4,463,487
              
              
              0.97Granted
              
              
              -
              
              
              0.65
              
              
              426,000
              
              
              0.65Exercised
              
              
              -
              
              
              
              
              
              -Forfeited/cancelled
              
              
              (295,500
              )
              
              0.85
              
              
              (210,000)
              
              
              0.85Options
                  outstanding at end of year
              
              
              4,383,987
              
              
              0.84
              
              
              4,679,487
              
              
              0.84Options
                  exercisable at year-end
              
              
              4,383,987
              
              
              0.84
              
              
              4,679,487
              
              
              0.84Weighted-average
                  fair value of options granted during the year *
              
              
              -
              
              
              
              
              
              0.22




*
            The
                fair value of each option granted is estimated on the date of grant,
                using
                the Black-Scholes option-pricing model with the following weighted
                average
                assumptions: dividend yield of 0% for all years; expected volatility:
                2005
                - 44%; risk-free interest rate: 2005 - 3.93%, and expected life:
                2005 - 3
                years.





The
      following table summarizes information about fixed share options outstanding
      at
      December 31, 2006:




**Options
                Outstanding**
            
            **Options
                Exercisable****RangeofExercisePrices**
            
            **NumberOutstandingat
                December31, 2006**
            
            **Weighted AverageRemainingContractual Life**
            
            **Weighted****Average****Exercise****Price**
            
            **NumberExercisableat December31, 2006**
            
            **WeightedAverage****Exercise****Price**$
            
            
            
            Years
            
            $
            
            
            
            $0.1-0.50
            
            
            783,421
            
            
            9.58
            
            
            0.26
            
            
            783,421
            
            
            0.260.65
            
            
            2,479,173
            
            
            6.33
            
            
            0.65
            
            
            2,479,173
            
            
            0.650.75-2.5
            
            
            1,121,393
            
            
            16.15
            
            
            1.72
            
            
            1,121,393
            
            
            1.724,383,987
            
            
            
            
            
            
            
            
            4,383,987




F-47




**BLUEPHOENIX
        SOLUTIONS LTD.**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**




**Note
      11 - Shareholders’ Equity (cont.):**




**C.**
            **Dividends:**




**1.**
            The
                Company has not paid any cash dividends on its ordinary shares in
                the past
                and does not expect to pay cash dividends on its ordinary shares
                in the
                foreseeable future.





**2.**
            In
                the event of a distribution of cash dividends out of retained earnings,
                regarding which the Company was tax exempt due to the “Approved
                Enterprise” status under the Israeli law of encouragement of capital
                investments, 1959, of its approved operations, the Company would
                have to
                pay a 25% tax on the said amount.The
                Company has determined that it will not distribute any amounts of
                its
                undistributed tax exempt income as dividend.





**Note
      12 - Monetary Balances in Non-dollar Currency:**




**December
                31,****2006**
            
            **2005****(in
                thousands)****ASSETS:**Current
                assets
            
            $
            12,422
            
            $
            16,128Long-term
                assets
            
            
            9
            
            
            5812,431
            
            
            16,186**LIABILITIES:**Current
                liabilities
            
            
            9,287
            
            
            11,984Long-term
                liabilities
            
            
            10,639
            
            
            4,68419,926
            
            
            16,668Net
                monetary liabilities
            
            $
            (7,495
            )
            $
            (482
            )





**Note
      13 - Taxes on Income:**




**A.**
            **Tax
                Benefits Under the Law for the Encouragement of Industry (Taxation),
                1969:**




The
      Company currently qualifies as an “Industrial Company” as defined by this law,
      and as such is entitled to certain tax benefits including, inter alia,
      depreciation at increased rates as stipulated by regulations published under
      the
      Inflationary Adjustments Law and has the right to deduct for tax purposes,
      over
      a period of 3 years, expenses relating to public issuance of shares. If
      realized, any tax benefit relating to issuance expenses is credited to
      additional paid-in capital.




F-48


**BLUEPHOENIX
          SOLUTIONS LTD.**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**




**Note
      13 - Taxes on Income (cont.):**




**B.**
            **Tax
                Rate Applicable to Income in
                Israel:**




On
      July
      25, 2005, the Law for Amendment of the Income Tax Ordinance (Amendment No.
      147)
      became effective. Pursuant to this amendment, the income tax applicable to
      Israeli companies will be gradually reduced from 34% in 2005 to 25% in 2010
      and
      henceforth. The regular corporate tax In Israel in 2006 is 31%. Deferred Income
      taxes balances were adjusted accordingly and effect of such adjustment was
      not
      material. This tax rate decrease is not expected to have a material effect
      on
      the Company’s financial position.





**C.**
            **Deferred
                Income Taxes:**




Deferred
      tax assets reflect the net tax effects of temporary differences between the
      carrying amounts of assets or liabilities for financial reporting purposes
      and
      the amounts used for income tax purposes. As of December 31, 2005 and 2006
      the
      Company’s deferred taxes were in respect of the following:





**December
                31,****2006**
            
            **2005****(in
                thousands)**Net
                operating losses carry forwards
            
            $
            27,251
            
            $
            25,034Software
                development costs
            
            
            1,169
            
            
            1,566Provisions
                for employee rights and other temporary differences
            
            
            824
            
            
            73529,244
            
            
            27,335Valuation
                allowance
            
            
            (29,233
            )
            
            (27,311
            )$
            11
            
            $
            24




*
            The
                Company’s management cannot determine whether it is more likely than not
                that the deferred tax asset relating to net operating losses will
                be
                realized.





**D.**
            **Non-Israeli
                Subsidiaries:**




Non-Israeli
      subsidiaries are taxed based upon tax laws in the country of domicile of
      the  respective
      subsidiary.





F-49




**BLUEPHOENIX
      SOLUTIONS LTD.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**Note
      13 - Taxes on Income (cont.):**




**E.**
            **Income
                before Taxes on Income is Composed as
                Follows:**




**Year
                ended December 31,****2006**
            
            **2005**
            
            **2004****(in
                thousands)**Domestic
                (Israel)
            
            $
            3,037
            
            $
            (1,560
            )
            $
            (5,097
            )Foreign
            
            
            1,670
            
            
            3,637
            
            
            8,792$
            4,707
            
            $
            2,077
            
            $
            3,695








**F.**
            **Taxes
                on Income Included in the Statements of
                Income:**




**Year
                ended December 31,****2006**
            
            **2005**
            
            **2004****(in
                thousands)**For
                the reported year - current:Domestic
                (Israel)
            
            $
            28
            
            $
            8
            
            $
            15Foreign
            
            
            286
            
            
            164
            
            
            98314
            
            
            172
            
            
            113Taxes
                related to prior years
            
            
            (609
            )
            
            (81
            )
            
            (133
            )Deferred
                taxes, net
            
            
            13
            
            
            58
            
            
            280$
            (282
            )
            $
            149
            
            $
            260




F-50




**BLUEPHOENIX
        SOLUTIONS LTD.**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**


**Note
      13 - Taxes on Income (cont.):**




**G.**
            **A
                reconciliation of the theoretical tax expense, assuming all income
                is
                taxed at the regular rates and the actual tax expense is as
                follows:**




**December
                31,****2006**
            
            **2005**
            
            **2004****(in
                thousands)**Income
                before taxes on income, per consolidated statements of
                income
            
            $
            4,707
            
            $
            2,077
            
            $
            3,695Theoretical
                tax expense (35% in 2004, and 34% in 2005 and 31% in 2006)
            
            
            1,459
            
            
            706
            
            
            1,293Decrease
                in taxes resulting from permanent differences:State
                income tax, net of federal benefit
            
            
            (4)
            
            
            (67)
            
            
            8Tax
                exempt income
            
            
            -
            
            
            -
            
            
            (246)Non-deductible
                expenses
            
            
            387
            
            
            282
            
            
            70Effect
                of different tax rates in foreign subsidiaries
            
            
            407
            
            
            (105)
            
            
            -Taxes
                related to previous years
            
            
            (609)
            
            
            (81)
            
            
            (133)Carry-forward
                losses and research and development costsfor
                which the Company provided an allowance
            
            
            (1,922)
            
            
            (649)
            
            
            (432)Other
            
            
            -
            
            
            63
            
            
            (300)Taxes
                on income in the consolidated statements of income - for the reported
                year
            
            $
            (282)
            
            $
            149
            
            $
            260Effective
                tax rate
            
            
            -
            
            
            7%
            
            
            7%





**H.**
            **Tax
                Losses:**




The
      Company and its subsidiaries in Israel have NOL carry forwards for income tax
      purposes as of December 31, 2006 totaling $52 million.





**I.**
            **Tax
                Assessments:**




The
      Company received final tax assessments in Israel through tax year
      2002.





F-51


**BLUEPHOENIX
        SOLUTIONS LTD.**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**


**Note
      14 - Supplementary Financial Statement Information:**




**A.**
            **Balance
                Sheets:**




**1.
                Trade Accounts
                Receivables:**




**December
                  31,****2006**
              
              **2005****(in
                  thousands)**Trade
                  accounts receivable
              
              $
              27,156
              
              $
              18,824Less
                  provision for doubtful accounts
              
              
              (667)
              
              
              (681)$
              26,489
              
              $
              18,143





**2.
                Other Current Assets:**




**December
                      31,****2006**
                  
                  **2005****(in
                      thousands)**Government
                      departments and agencies
                  
                  $
                  287
                  
                  $
                  545Advances
                      to suppliers and others
                  
                  
                  140
                  
                  
                  332Employees
                  
                  
                  -
                  
                  
                  132Prepaid
                      expenses
                  
                  
                  1,697
                  
                  
                  1,000Related
                      parties
                  
                  
                  30
                  
                  
                  12Short-term
                      lease deposits
                  
                  
                  193
                  
                  
                  273Interest
                      and other income receivable
                  
                  
                  749
                  
                  
                  201$
                  3,096
                  
                  $
                  2,495





**3.****Accounts Payable and Accruals -
                Other:**





**December
                31,****2006**
            
            **2005****(in
                thousands)**Government
                departments and agencies
            
            $
            370
            
            $
            336Employees
                and wage-related liabilities
            
            
            4,994
            
            
            4,018Accrued
                expenses and other current liabilities
            
            
            1,565
            
            
            2,570$
            6,929
            
            $
            6,924





F-52


**BLUEPHOENIX
        SOLUTIONS LTD.**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**


**Note
      14 - Supplementary Financial Statement Information
      (cont.):**




**A.**
            **Balance
                Sheets (cont.):**




**4.****The
                Company’s Long-lived Assets are as
                Follows:**




**December
                31,****2006**
            
            **2005****(in
                thousands)**Israel
            
            $
            24,892
            
            $
            17,718U.S.A.
            
            
            10,796
            
            
            9,028Europe
                (other than Denmark)
            
            
            1,590
            
            
            3,118Denmark
            
            
            501
            
            
            351$
            37,779
            
            $
            30,215




Long-lived
        assets information is based on the physical location of the assets at the
        end of
        each of the fiscal years.
  The
        Company does not identify or allocate goodwill by geographic
        areas.




**B.**
            **Statements
                of Operations:**




**1.****Geographic Areas
        Information:**




**Sales:
      Classified by Geographic Areas:**




The
      Company adopted Statement of financial Accounting Standard No. 131, "Disclosures
      About Segments of an Enterprise and Related Information", ("SFAS No. 131").
      The
      Company operates in one reportable segment (see Note 1 for a brief description
      of the Company's business). the total revenues are attributed to geographic
      areas based on the location of end customers.





The
      following present total revenues for the years ended December 31, 2004, 2005
      and
      2006:





**Year
                ended December 31,****2006**
            
            **2005**
            
            **2004****(in
                thousands)**USA
            
            $
            15,048
            
            $
            17,423
            
            $
            20,438Europe
                (other than Denmark)
            
            
            28,449
            
            
            18,643
            
            
            15,860Denmark
            
            
            10,304
            
            
            12,334
            
            
            10,122Israel
            
            
            10,156
            
            
            7,991
            
            
            8,353Other
            
            
            4,047
            
            
            2,556
            
            
            2,413$
            68,004
            
            $
            58,947
            
            $
            57,186





F-53
 
  **BLUEPHOENIX
          SOLUTIONS LTD.**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
  Sales
          by geographic areas are determined based on the customer’s
          location.


**Note
      14 - Supplementary Financial Statement Information
      (cont.):**




**B.**
            **Statements
                of Operations (cont.):**




**2.**  **Principal
        Customers:**




Major
      customer over 10% of the Company’s revenues:





**2006**
            
            **2005**
            
            **2004**Customer
                A
            
            
            11%
            
            
            17%
            
            
            15%Customer
                B
            
            
            15%
            
            
            -
            
            
            -





**3.**  **Financial
        Expenses, Net:**




**Year
                ended December 31,****2006**
            
            **2005**
            
            **2004****(in
                thousands)**Interest
                income
            
            $
            237
            
            $
            191
            
            $
            205Foreign
                currency translation adjustments (see Note 1A4)
            
            
            (50)
            
            
            (580)
            
            
            69Interest
                expense
            
            
            (1,117)
            
            
            (898)
            
            
            (632)Debentures
                and convertible debt financial expenses
            
            
            (2,981)
            
            
            (938)
            
            
            (688)Income
                from derivative financial instruments andmarketable
                securities
            
            
            396
            
            
            247
            
            
            164$
            (3,515)
            
            $
            (1,978)
            
            $
            (882)




**4.**  **Gain
        on Realization of Shareholdings:**




**Year
                ended December 31,****2006**
            
            **2005**
            
            **2004****(in
                thousands)**Cicero
            
            $
            -
            
            $
            -
            
            $
            171Other
            
            
            -
            
            
            -
            
            
            (59)$
            -
            
            $
            -
            
            $
            112




**5.**  **Other
        Income, Net:**




**Year
                ended December 31,****2006**
            
            **2005**
            
            **2004****(in
                thousands)**Gain
                (loss) on sale of property and equipment
            
            $
            -
            
            $
            35
            
            $
            (14)Dividend
                income (*)
            
            
            282
            
            
            -
            
            
            703Other
            
            
            -
            
            
            69
            
            
            286$
            282
            
            $
            104
            
            $
            975




F-54




**BLUEPHOENIX
      SOLUTIONS LTD.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**




(*)
            Dividend
                income from Steps Ventures, An Israeli venture capital investment
                group,
                in which the Company holds 375,000 shares representing 3.75% of their
                outstanding share capital.





F-55




**BLUEPHOENIX
        SOLUTIONS LTD.**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **Note
        14 - Supplementary Financial Statement Information
        (cont.):**




**C.**
            **Earnings
                Per Share:**




Basic
      earnings per share (“EPS”) was computed based on the average number of shares
      outstanding during each year, after giving retroactive effect to stock dividends
      and stock splits. In computing diluted EPS, effect was given to share options
      outstanding in each period, using the treasury stock method, provided that
      such
      effect is not anti-dilutive.




The
      following table sets forth the computation of basic and diluted net earnings
      per
      share.





**Year
                ended December 31,****2006**
            
            **2005**
            
            **2004****(in
                thousands)****1.****Numerator:**Amount
                for basic earning per share - income available toshareholders
            
            $
            4,672
            
            $
            1,789
            
            $
            2,846Effect
                of dilutive securities
            
            
            -
            
            
            -
            
            
            276Amount
                for diluted earnings per share - incomeavailable
                to shareholders
            
            
            4,672
            
            
            1,789
            
            
            3,122**2.****Denominator:**Denominator
                for basic net earnings per share - weightedaverage
                of shares
            
            
            13,889,483
            
            
            13,556,627
            
            
            13,522,866Effect
                of dilutive securities:Employee
                share options
            
            
            481,421
            
            
            403,382
            
            
            477,713Dilutive
                effect of issued debentures
            
            
            -
            
            
            -
            
            
            678,447Potential
                dilutive ordinary shares
            
            
            481,421
            
            
            403,382
            
            
            1,156,160Denominator
                for diluted net earnings per share - weightedaverage
                shares and assumed exercise of options
            
            
            14,370,904
            
            
            13,959,909
            
            
            14,679,026Basic
                net earnings per share
            
            $
            0.34
            
            $
            0.13
            
            $
            0.21Diluted
                net earnings per share
            
            $
            0.33
            
            $
            0.13
            
            $
            0.21




Employees
      share options and warrants issued to purchase 1,315,935, 1,677,609 and 1,318,817
      shares at various prices between $4.5 and $10.5 per share were outstanding
      during the years of 2006, 2005, and 2004, respectively, but were not included
      in
      the computation of diluted EPS because the options’ exercise price was higher
      than the average market price of the ordinary shares.




715,649
      and 3,048,930 shares underlying the convertible debentures and notes were
      excluded from the computation of diluted EPS in 2006 and 2005 respectively,
      since their inclusion would have had an anti-dilutive effect on
      EPS.




F-56


**BLUEPHOENIX
        SOLUTIONS LTD.**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**


**Note
      15 - Transactions with Related Parties:**








**Year
                ended December 31,****2006**
            
            **2005**
            
            **2004****(in
                thousands)****Formula,
                its subsidiaries and other associated companies:****A.**
            Selling,
                general and administrative expenses:management
              fees (Note 10A1)
            
            $
            180
            
            $
            180
            
            $
            180**B.**
            Revenues
                from sale of software conversion tool and software services to related
                parties
            
            $
            1,214
            
            $
            1,694
            
            $
            1,973**C.**
            Cost
                of revenues relating to services from related parties
            
            $
            1,217
            
            $
            1,761
            
            $
            2,315**D.**
            Reimbursement
                related to services rendered to affiliated and other
                companies
            
            $
            43
            
            $
            41
            
            $
            235





**E.**
            Arie
                Kilman was nominated as the Company’s Chief Executive Office in May 2003.
                In his former position as Liraz’s chairman of the board of directors, he
                was granted by Liraz in May 2002 a loan in an amount equal to
                approximately $300 thousand, linked to the Israeli Consumer Price
                Index,
                and bearing annual interest at a rate of 4%. Under the terms of the
                loan,
                the loan was repaid to Liraz in four equal annual installments, the
                last
                one of which was made in 2006. Mr. Kilman has fully complied with
                all loan
                payment obligations under the loan
                agreement.





**G.**
            In
                January 2006, the company entered into a services agreement with
                TIS Ltd.,
                ("TIS"), a Cypriot company. Under the agreement, TIS provided the
                Company
                with consulting and other professional services. When the Company
                signed
                the agreement with TIS, 38.8% of the share capital of TIS was held
                by CTI
                Ltd., ("CTI"), a Cypriot company. Mr. Kilman, the Company’s chief
                executive officer and director holds 49% interest in CTI. Therefore,
                the
                transaction was considered as a related party transaction and the
                company
                obtained the necessary approvals required under Israeli law. In November
                2006, Mr. Kilman notified the company that CTI sold the shares it
                held in
                TIS and it was no longer a shareholder of TIS. In 2006, the company
                paid
                fees to TIS in an aggregate amount of $300
                thousand.





**Note
      16 - Subsequent Events:**


In
      2007
      first quarter, several investors converted $1.2 million principal amount of
      debentures issued in March 2004 into 229,008 ordinary shares, and $2.0 million
      principal amount of debentures issued in March 2006 into 443,334 of the
      Company's ordinary shares (see also Note 11B2).





F-57